naked capitalism

Boy, the equity infusion in Citi was in some ways predictable, but it happened earlier than I anticipated. Guess the bank learned from its last rescue by Prince Alwaleed not to wait until they are desperate to find a suitor. Its alternative to shore up its weakening equity base was selling assets, but with many financial firms also under stress, it isn’t the best time to be hocking businesses.

The yield on the convertible preferred, 11%, is staggering. Even Countrywide in its August bailout by Bank of America, paid only 7.25%, although the conversion was deeply in the money on that deal at the time of closing (no longer!). Based on today’s closing price of $30.70, this conversion feature is slightly out of the money, and the conversion right cannot be exercised prior to 2010, and the conversion price rises in subsequent years. Nevertheless, I would take yield over appreciation in the current environment. While the dividend yield is only slightly above the yield on Citi’s common, the common dividend will be cut before the preferred would be. Both the common dividend and terms of the Abu Dhabi deal show how much doubt there is over the bank’s prospects.

This deal will be consummated before Citi releases its audited financials for 2007. I would love to be a fly on the wall and learn what reps and warranties Abu Dhabi requires.

From the Wall Street Journal:

The investment by the Abu Dhabi Investment Authority will help rebuild Citigroup’s capital levels…

As a result of the deal, the investment authority known as ADIA will become one of Citigroup’s largest shareholders, with a stake of no more than 4.9%. The stake will exceed that of Saudi Prince Alwaleed bin Talal, long known as one of Citigroup’s largest shareholders, according to a person familiar with the situation.

“This investment, from one of the world’s leading and most sophisticated equity investors, provides further capital to allow Citi to pursue attractive opportunities to grow its business,” said Sir Win Bischoff, the bank’s acting chief executive officer, in a statement.

The investment underscores the growing role that Middle Eastern investors are taking outside their home turf. Separately yesterday, an investment company owned by Dubai’s ruler, Sheikh Mohammed bin Rashid al-Maktoum, bought a stake in Sony Corp. ADIA, which has almost $1 trillion under management, this summer bought a small stake in Apollo Management LP.

“This investment reflects our confidence in Citi’s potential to build shareholder value,” said ADIA’s Managing Director, Sheikh Ahmed Bin Zayed Al Nahayan.

In exchange for its investment, ADIA will receive convertible stock in Citigroup yielding 11% annually. The shares are required to be converted into common stock at a conversion price of between $31.83 and $37.24 a share over a period of time between March 2010 and September 2011. The investment, which came together in about a week, is expected to close within the next several days.

On Monday, shares of Citigroup fell 6.2% to $29.75 in 4 p.m. composite trading on the New York Stock Exchange.

ADIA, which is a client of Citigroup, won’t have any special ownership rights and no role in Citigroup’s management or governance. It also won’t have any right to name a member to Citigroup’s board….

The bank is at risk of more losses due to the credit-market turmoil, leading to widespread concerns that it and other financial institutions will be forced to curtail lending. Furthermore, Citigroup’s U.S. consumer business, which includes retail banking and credit cards, is trailing key rivals like Bank of America Corp. and J.P. Morgan Chase & Co.

The WSJ contained an all-too-typical illustration of Wall Street Journal’s habit of shading its reporting reporting:
nvestors have increasingly expressed concerns about Citigroup’s “tier 1″ capital levels — a common measure of a bank’s capital adequacy — which for the first time in years fell below its 7.5% target in the third quarter. Although the bank is still considered to be well-capitalized, investors worried that Citigroup would be forced to cut its dividend.

Citi paid a vastly higher dividend that Countrywide did, and Countrywide was (and still is) at risk of going bankrupt. The Financial Times gave a foursquare assessment:

The impact of credit market turmoil combined with a previous string of acquisitions, including Nikko Cordial in Japan, has left Citi’s balance sheet under strain.

Its Tier One capital ratio fell to 7.3 per cent at the end of the third quarter, below Citi’s target of 7.5 per cent, and has fallen further since. The company has committed itself to returning the ratio to its target by the end of June. The issue of mandatory convertible securities to ADIA would lift that ratio by about 0.5 percentage points.

And Citi provides the usual lipstick on a pig. Again from the FT:

There have been a couple of dozen large issues of such securities in the past few years, including by companies such as Fortis and CIT. The yield premium and average conversion premium in the Citi deal are in line with the average for previous deals, according to a senior executive.

The “yield premium” being within norms nicely finesses the issue of how highs Citi’s common yield is, 7% based on today’s closing price. And I have a sneaking suspicion if I saw the terms comparison I might have more than a few quibbles with what was considered to be a comparable transaction.

Update 11/27, 10:20 PM: Andrew Clavell has decomposed the Abu Dhabi deal into its constituent parts, such as puts and calls, and concludes it isn’t bad at all (Felix Salmon translates Clavell’s analysis into lay terms). This is a very useful contribution to the discussion.

I will confess to not having realized the deal was a mandatory convert (that limits how long the 11% coupon is paid, while traditional convert preferred have a longer life and conversion is often optional, and with an 11% dividend you’d pretty much never convert unless there was considerable appreciation in the common). That does reduce the cost of this exercise somewhat.

However, my quibble isn’t with Clavell’s analysis, but the way he frames his conclusions. At a 7+% yield, issuing common, or any security priced in relationship to common, is an expensive exercise for Citi. With that rich a yield, it’s a guarantee that the yield is propping up the price (I know of at least two people who hazarded to buy the stock recently based on its yield). Similarly, the bank is committing itself to an 11% cash outlay, even with the tax deductions. If Citi continues to be stressed financially (a near certainty), being committed to high (relative to the amount raised) outflows is not a pretty position to be in. The overall economics may appear attractive, but that calculus misses the risks implicit for Citi of having fixed commitments. To put it in economic terms, Citi has a strong liquidity preference, and this deal makes demands on liquidity. That works against economic considerations that might otherwise be favorable.

Common dividends, on the other hand, can be cut, but one can only guess how hard it would have been for Citi to sell this much in straight common (as in how much would it have depressed the price). (An aside: Salmon argues that cutting the dividend might increase the stock price. Huh? A dividend reduction would tank the common).

The other consideration is that one use of cash, at least according to Bloomberg, was to preserve the common dividend. Yikes. Now cynically, Rubin had to say that Cit was going to maintain its dividend. The firm wasn’t going to have much success selling a security with a forced conversion to equity if it did’t act as if it intended to maintain a dividend that keeps the stock from plummeting.

But you don’t use a financing to pay the outflow on another financing (it’s another matter if you use one financing to retire another). A new financing should be used to shore up the balance sheet, but Citi’s high dividend stock puts it in a very difficult position. Any equity-like instrument is likely to have a high cash outlay attached. So Clavell is no doubt right that this is a relatively attractive option for Citi, but keep in mind that Citi doesn’t have good options.

We’ll see if Citi cuts the dividend after a long enough interval that they can tell Abu Dhabi that circumstances had changed. If things continue to deteriorate at the bank, that could take as little as six months.