Citi Won’t Sink Yet

Story Highlights:

• In line with recent bailouts favoring banks, the feds and Citigroup executives put together a plan to insure the bank's troubled assets and inject capital this weekend.
• The government insurance should help ease capital requirements and make it easier to attract additional funding in the future.
• After the recent TARP flip-flop, the plan amends some of the messaging inconsistency—and Financials seemed to respond favorably on Monday.

(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

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As a sector, Financials had a rough time of it last week. Citigroup led the way down, but we thought it unlikely the firm would pull a Lehman. So far, the government's consistently favored banks with bailouts. True to form, the feds spent this weekend hashing out a government aid package with Citi's executives.

In October, Citi received $25 billion of the $125 billion doled out to major banks in the government's first round of capital injections. This weekend's deal injects a further $20 billion in exchange for preferred shares, subject to Washington's conditions restricting executive pay and requiring the company implement the FDIC's mortgage modification program.

In addition, the aid package insures some $306 billion in troubled mortgage-related assets with a $29 billion deductible (the loss Citi has agreed to take, given further deterioration of the assets). This guarantee will expire in 10 years for residential assets and 5 years for non-residential assets. In exchange for the insurance, Citi will issue an additional $2.7 billion in warrants to the feds.

The government guarantee provides some balance sheet relief by allowing Citi to reduce the risk weighting of the burdensome assets to 20%. (A risk weighting helps convert a security's default probability to the amount of capital a firm needs to hold against it.) Also, the newly insured assets may be used as collateral to attract additional funding as needed.

The plan is the first to back toxic mortgage assets since the Treasury switched TARP's focus from purchasing bad debt to capital injections, then suspended further spending for the immediate future—a flip-flop that perhaps caused some of last week's downward momentum in markets. The deal displays a continued willingness to back large banking institutions struggling with mortgage-backed assets on a targeted basis—perhaps a better solution than the open reverse auction first proposed by the Treasury. (And granted, stocks have been historically volatile of late, but we noticed S&P 500 Financials finished almost 19% higher Monday—the single biggest one-day gain in the 39 years of sector-specific data on record.*)

In our opinion, if the government has to be involved, it's better to display strength and consistency—we hope the feds agree and act accordingly from here on out.

* Source: Bloomberg