Updated from 11:32 a.m. ESTCitigroup ( C) and the U.S. government reached a deal in which the government will raise its stake in the embattled bank. In a press release Friday, Citigroup said it will issue common stock in exchange for preferred securities, which the bank said will "substantially increase" its tangible common equity without any additional U.S. government investment. CEO Vikram Pandit, on a conference call Friday morning, said that based on the company's own conservative stress tests, the plan "should take capital issues off the table even in a stressed environment." "Like all financial services companies we still have to navigate through a tough environment but by putting this capital structure issue behind us once and for all we can lead from strength by focusing on our clients and building our business to maximize the earnings power of the company, which is ultimately what will allow us to rebuild the stock price," Pandit said. However, the immediate reaction for many investors was to flee. Citi shares closed down 39% to $1.50. Citi will offer to exchange common stock for up to $27.5 billion of its existing preferred securities and trust preferred securities at a conversion price of $3.25 a share, a 32% premium over Thursday's closing price of $2.46. The U.S. government will match this exchange up to a maximum of $25 billion of its preferred stock at the same conversion price. Other private investors will convert some of their preferred stock in Citi to common shares. The Government of Singapore Investment Corp., Saudi Arabian Prince Alwaleed Bin Talal, Capital Research Global Investors and Capital World Investors are among the private investors that said they would participate in the exchange.
Along with Citi, other big banks sold off Friday. Bank of America ( BAC) and JPMorgan Chase ( JPM), who are with Citi as part of the Dow Jones Industrial Average, and Wells Fargo ( WFC) all fell. Citi's deal with the government does not come as a surprise and the company's shares had jumped 26.2% from the time the news broke late Sunday through Thursday. Fox-Pitt Kelton Cochran Caronia Waller analyst David Trone writes in a note Citi shares plunged on Friday because short sellers from preferred stock holders sought to hedge their newfound common position. "As we've said all week, the issue is that of capital composition not capital amounts. Citi's action demonstrates this -- it is not raising capital, but changing its composition," Trone writes. He expects the stock to trudge toward $3 a share "once the emotion of the moment passes and technical factors are cleared out," Trone adds. Tim Ghriskey, the chief investment officer of Solaris Asset Management, says fear remains that the government could exert even more control or completely take over Citi. "Short sellers are, I think, driving the stock down and towards that ultimate conclusion," Ghriskey says. "It's sort of a self-fulfilling prophecy. If short sellers drive it down then the government won't have a choice." Solaris does not own any shares of Citi. In answer to an analyst's question however, Pandit said Citi execs "completely remain in charge of the day-to-day operations of the company." "Of course the government holds a significant amount of common stock invested in us, but our commitment we have had to every shareholder to provide an exceptional return as we get through this cycle remains unchanged," he said. "And in many ways, for those people who have a concern about nationalization this announcement should put those concerns to rest."
Under the capital initiative, the government will own approximately a 36% stake in Citi, while preferred stock holders will own 38% and common holders will hold 26% of the stock. "In our analysis, we had worried that a bank owned 70% by the U.S. government would create operational and strategic hazards, and now the 36% stake is less problematic. The ownership will make the government's eventual exit from the company much easier under common shares," Trone writes. Citi's earnings will also benefit from the elimination of the preferred dividend burden, though it is still paying trust preferred dividends, Trone writes. All three rating agencies downgraded Citi's preferred stock ratings on Friday given the suspension of dividends. "The decision to suspend dividends on certain preferred stock issues likely will pressure holders to accept the terms of the exchange offer, which represents a value less than par at Citi's recent share price," S&P said. "We believe there is a risk that Citi's future access to the capital markets could be impaired by this action. "More broadly, we are also concerned that Citi's action could mark a tipping point for the financial institutions sector, and serve as a visible precedent for other companies considering a similar course of action," the analysts said. Preferred dividend ratings aside, the ratings agencies also weighed in Citi capitalization changes. Moody's Investor Services lowered its ratings on Citi's senior and junior debt issued as well as its deposit ratings given that "Citigroup will emerge from the current economic crisis with a different mix of core businesses and a smaller scale, which could diminish its relative importance to the U.S. banking system over the long run," according to a note.
Both Fitch Ratings and Standard & Poor's affirmed its long and short-term debt ratings. Fitch downgraded the company's individual rating to "E" from "C/D" due to its heavy exposure to the deteriorating macro-economic environment and significant balance sheet stress, it said. S&P also lowered ratings on Citi's other rated hybrid capital issues to "CC" from "BB," and placed these ratings on CreditWatch with developing implications.