Duke Research Advantage

You hear the buzz about the nationalization of Citi?

What does this mean?

The U.S. government has dropped $45 billion of cash on Citi and another $250b in debt backstops (guarantees).

There is talk of converting some of the $45b in preferred stock into equity to get 40%.

Well, the current market value of Citi’s equity is only $10b. Hence, you don’t need to use all of the $45b to get 40%. However, I am afraid that they will use (or blow) all of it. That would be like the American taxpayer shelling out $10 for stock that’s worth $2. It is like buying toxic assets worth only 20 cents on a dollar for full value. It would be yet another incarnation of the trademark government strategy during this crisis (whether Democrat or Republican): Taxpayer=Loser

See my interview on the topic on BNN.

Read more …

Reasons for the Preferred Conversion:

• Makes the other preferred shareholders and debt holders less nervous. It gives them a cushion. In usual circumstances, the existing preferred holders do not convert (think of their investment as like debt, they get a fixed dividend which is like a coupon). You lose that coupon with common equity. Also, you lose priority if the firm goes belly up. Hence, the government conversion gives the other preferred shareholders and the debt holders some breathing room.
• Makes it possible for company to go out and raise additional preferred — replacing the government preferred.
• Allows Citi to potentially pass one of the “stress” tests (which have not been revealed yet), which is the tangible equity ratio (tangible equity/tangible assets). Preferred does not count as tangible equity – but once it is converted to common, it does. Right now that ratio is too low (1.5 for Citi).
• They don’t need to convert all the preferred to give the government 40%. Even though less than majority, it would substantially change the board and management dynamics. I have long argued that C and BAC need to start operating to reflect the best interest of their largest stakeholder, the American taxpayer. Currently, they put shareholders first. Shareholders are lucky to have any value. Citi has been zombie for quite a while. The only reason the stock has value is the government capital injections and guarantees.
• Optics. Nationalization smacks of a Soviet strategy — it is un-American. 40% is that it is technically not nationalization — but certainly a prelude to nationalization.

What to do:

1. Let’s stop this ad hoc incrementalism. We have wasted too much time (and too many jobs) by waffling and taking half steps. We need to act decisively.

2. Identify the good banks and the zombie banks.

3. Relegate all the zombies to the FDIC who will sell the assets in an orderly way over a number of years and distribute deposits to healthy financial institutions. We don’t need 8,500 banks. We must end the too big to fail policy.

4. Purchase trouble assets at fair market value from good banks to cleanse the balance sheets. Purchase at fair market value will allow taxpayers to benefit from the upside. The current proposal of private participation in the purchase of troubled assets is half-baked. It does not make sense for the government to lend money to private investors so that the private investors get all the upside and the taxpayer takes the downside (again that is a Taxpayer=Loser policy).

5. Nationalize now certain financial institutions that are salvagable as going concerns. Nationalization is a temporary evil. In addition, it gives the taxpayer some upside when the company goes public. There are certain banks where there is so much uncertainty that they won’t make loans because they need to hoard capital. Their corporate customerss are worried. The uncertainty is dysfuctional. Nationalization breaks the spiral.

6. Only “Smart” Nationalization please. This means (i) professional management and Board of Directors – not government bureaucrats; (ii) new corporate policies directed to benefit the major stakeholder, the U.S. taxpayer; (iii) completely rewrite risk management policies to greatly minimize the chance of other crisis like this; and (iv) plan for an Initial Public Offering in a five to seven years.