# Citigroup Arithmetic Explained

Since I’ve been writing about preferred and common stock so much this week, I thought I would just try to explain the arithmetic of the Citigroup deal announced today. (By the way, it isn’t a done deal: all it says is that Citi is offering a preferred-for-common conversion to its outside investors, and the government will match them dollar-for-dollar, although the WSJ says that several investors have agreed to participate.)

Right now, according to Google Finance, Citi has 5.45 billion common shares outstanding. It is offering to convert up to \$27.5 billion of preferred shares held by “private” investors other than the U.S. government (like the government of Singapore and Prince Alwaleed) into common shares, at a conversion price of \$3.25. That would create another 8.46 billion shares. For every dollar that is converted, the U.S. government will also convert one dollar of its preferred stock, up to \$25 billion; that is the \$25 billion from the first round of recapitalization back in October, which is paying a 5% dividend. (Fortunately someone realized we should convert that before converting the second chunk, which pays 8%.) That would create another 7.69 billion shares. So if everyone converts as much as possible, there will be 21.60 billion shares outstanding, of which the U.S. government will own 7.69, for an ownership stake of 36%, the number you read in the papers. (Actually, if the private investors convert exactly \$25 billion and not \$27.5 billion, the government would own 37%, but that’s a detail.) The other private investors would own 39%, and current shareholders would own 25%.

The government got some warrants on common shares in connection with the earlier recapitalizations. I assume the warrants it got for the first investment will no longer exist (because that first investment is being “paid back”), but the warrants on the second investment, if exercised, would presumably push the government up a couple percentage points.

Where did the \$3.25 price come from? Who knows. Yesterday’s closing price was \$2.46. If that price had been used, the government’s target ownership percentage would have been 38% instead of 36%, which seems immaterial. Presumably it was the product of a negotiation, since it’s hard to see how the investors involved – especially the ones that are not the U.S. government – would have wanted to pay more than the current stock price for a company that is clearly in trouble. At least they didn’t use \$3.46, which is the price that any future Citigroup convertible preferred stock can be converted at.

And why did the stock plummet (now \$1.57), despite the fact that the preferred shareholders are “paying” \$3.25 per share? Probably because the common shareholders realize this is largely an accounting game, and the preferred stock wasn’t worth its face value to begin with. The current shareholders’ ownership stake could fall from 100% to 25%, but the stock is only down 36%. This implies that the market thinks that the total common shareholders’ stake will more than double in value, but won’t quadruple in value (the amount required to offset the dilution). Their stake increased in value because (a) Citigroup can avoid paying dividends on all the preferred stock that gets converted and (b) that much less money will have to get paid back to preferred shareholders in case of liquidation. But there’s still a large cloud hanging over Citi, and it’s on the asset side of the balance sheet.

## 55 thoughts on “Citigroup Arithmetic Explained”

1. MK says:

So, My initial reaction in the last post is correct. If the U.S. were to convert enough preferred stock in the various banks to common, or the banks themselved were to elect to do so, then it is possible for the bank to be “nationalized” without FDIC like action to do so.

2. Mark Douma says:

Prof. Kwak,

I am no economist but … Based on FDIC Statistics on Depository Institutions (www2.fdic.gov/sdi/main.asp with some effort), I don’t see the problem. 7085 banks have assets of \$12T and 512 with assets >\$1B have assets of \$11T. Tier 1 capital is 7.13% of total assets for all, 6.86% for the largest 512. (Percentage wise, Citigroup is similar, I think.) Derivatives are 1,817% of assets for the largest, negligible for the rest. The largest component is interest rate swaps at 1148%. A 0.6% loss on these wipes out Tier 1, but this is the principal on which the swap is based. This loss would require a uniform bet by all banks with non-bank parties that interest rates will be X% and they turn out to be X.6%. Moreover, if these are swaps, shouldn’t they mostly net out? The net of written (109%) minus purchased (104%) interest rate option contracts is 5% of assets. Could all of these be improvident? Of credit derivatives, banks are beneficiaries of 73% and guarantors of 71%. Commitments to buy foreign currencies at 83% should be a winner today and so on. There seems to be a large fluffy derivative tail wagging the asset dog. Can you cut through the fluff better than I? There is no doubt about the answer. Also, what is wrong with starting from the position that the net external debt of the planet is zero? Thanks for the good work.

3. Thanks, James. This was very helpful.

4. sarah southwick says:

what is harder to understand is this when is the small investor best guided to invest in citi if at all now before the final “36%” gov share or after the exchange for preferreds is out of the way or forget it for months re: common stock purchase goes.

5. Prof. Kwak —

“I assume the warrants it got for the first investment will no longer exist (because that first investment is being “paid back”)”

In what sense is the investment being “paid back”? The preferred shares are being converted to common; that is not a repayment… I believe the warrants are separate instruments (essentially call options).

I suspect we taxpayers still own the warrants, but since they have a conversion price of over \$10, we will not be exercising them any time soon.

6. Re: the warrants

The term I was looking for is “exercise price”. The warrants have an exercise price of something like \$10/share. (Although “subject to customary anti-dilution adjustments”, so maybe our exercise price will be divided by 4 when the common gets diluted.)

7. Phil McClelland says:

What’s the motive for private investors other than the U.S. to convert from preferred to common stock?

8. James Kwak says:

Nemo: Good point. I may be wrong. I was thinking that, conceptually, the government was paying \$3.25 in cash for each common share, and then Citi was turning around and paying that cash back to retire the preferred shares. In that sense they are paying back the preferred shares (debt) using the “proceeds” from selling the government the common shares. But I may be wrong about this.

Phil: Very good question. One possibility is that they just think Citi is in such bad shape that they don’t think they’ll get paid back on the preferred anyway. See Felix Salmon on this point: http://www.portfolio.com/views/blogs/market-movers/2009/02/27/citigroup-bailout-math.

Another possibility is that I heard in some article I can’t find right now that Citi was going to stop paying dividends on preferred shares. Sometimes the issuer can unilaterally stop paying dividends on preferred. Ordinarily those dividends “accrue,” meaning that eventually you have to pay those dividends. But in this case, Citi would be cutting off the short-term cash flow to preferred shareholders, and if they are worried about Citi going bust, then they would never get those dividends.

9. EJK says:

Isn’t amazing how “normal” it is now to talk about handing money over to the banks. We gave them 25 bln and now we have 12.3 bln in common shares. It seems like there was a time when people wouldn’t have allowed something like this.

10. m tracy says:

There are two VERY big points not being discussed. That is the elimination of \$50 billion of preferred and \$3+ billion of interest (ok dividend). From the perspective of the common looking up, preferred looks just like debt, so basically, the common holders at about \$10 billion MC give up 75% or \$7.5 billion of value to get \$50 billion of debt removed from the balance sheet. This is the sweetest deal ever, and a big BUY to me. Now that your equity partners are the US government and soverign funds, is there any chance ok bankruptcy? Buying Citi common is like buying 5 yr treasuries.

11. Daniel says:

If the government is only matching the private conversion, might this be a lot of hot air that amounts to very little?

Given that most of response I’ve seen seems to think that the conversion rate is a giveaway to Citi, where is all of that private conversion that the government will match coming from?

12. AWS says:

As I understand, the government has overpaid for Citi common stock and has also assured that Citi can now pass the stress test. Are my conclusions correct?

13. Sean C says:

Again: what is the motivation to convert for Alwaleed, etc? the USG is in the bailout business, sovereign wealth funds are not. Please explain.

14. VG says:

At this point, it is hard to explain the equity value of Citi without discussing the option value. In my view, the intrinsic value of Citi is all but zero and there is only option value left in the stock, driven by the uncertainty in the asset prices on its books.

15. I cannot pretend qualification to answer the questions you pose, but will add “counter questions” in the form of assertions which may be false and certainly should be treated as questions, not statements of fact.

The fact that swaps net out, nominally, does not relieve them of their impact, because the operation of netting them out leaves the stuff the cover uncovered.

Improvident is hardly the word for it. A lot of the underlying stuff is fraudulent, the fraud is well known and systematic. The institutions trading in it do not know and cannot determine the value, because they (typically?) don’t even have the paper on which the instruments are based.

http://www.huffingtonpost.com/william-k-black/the-two-documents-everyon_b_169813.html

The large derivatives tail is wagging the asset dog because it has all these ticks on it that cause it to significantly outweigh the dog.

16. This move certainly would have improve the ability to pass the stress test. The exchange has not been done yet, and whether the price to the government is too high is in doubt. In private transactions major equity purchases are sometimes at significant premiums; presumably the purchaser thinks that reflects economic value. In this case private buyers are also involved, which could be interpreted to mean that the payment is at a price set by a market with few participants but lots of money. (See caveat to reply to Mark Douma, above.)

17. Billy Jones says:

very insightful….the peoples trust is still low but will get better (IMHO)

18. He sees a chance, at these prices, to make some money. He participated in setting a negotiated price which gives him that opportunity, but is acceptable to the corporate officers representing the stockholders. Both the price, and the possibility of making money, are probably increased by the 50% participation of the US in the deal.

You, based on the “bailout” term, apparently question his assessment that this is a profit opportunity. Fair enough. (At least that is one, market based, way of looking at it.)

19. Billy Jones says:

just sit back and watch then

20. MDS says:

I am likely being very slow here, and I admit I do not understand many of the posts above. But it seems to me that the point is the “arbs” are not paying anywhere near 25 / share in the secondary market, so at the conversion ratio they ar getting common shares at even less than the comoon share price of roughly 1.60. Then they sell common to complete the arbitrage. The ambiguity is whether the government will convert them based on par value of preferred, or just give them 7.6 shares of common for their secondary markt preffered shares. Is it tht simple?

21. Billy Jones says:

yes

22. MDS says:

Billy: I thought at curent valuations, one “Jefferson” would buy you 12.5 shares of the common…

23. Billy Jones says:

i will put my money where my mouth is……….:)

24. Billy Jones says:

phone call will be made in the a.m.

25. Billy Jones says:

mit,,,please keep this site up////there are many yeras of problems ahead…..i’m still young….and i believe the dialogue on this site has helped the world….europe will follow….faith and good wishes….

26. rakesh says:

the clear message is that the government will support citi no matter what and that citi will continue to outfox the gov.

27. Billy Jones says:

yep….but believe has been revolation between citi palyers and the gov…..mutual respect,,i might add

28. Anonymous says:

Hi,

I just have one question. Should I sell my preferred shares? I own citigroup preferred shares, c-ps. I paid a par value of \$25.00 per share when I bought them 6 years ago and they pay a 6% dividend. They recently hit a low of \$4.26 per share and today were up 16% ending at \$8.50 per share. I have no idea how to interpret what happened today. I want to recoup as much as I can, and I don’t want to lose everything.

29. Josh F says:

According to David Faber of CNBC, prior to the deal the preferred stock was worth about \$.15 on the dollar. If I understand all this correctly, that means that for the private investors with big preferred stakes who took part in this conversion, converting preferred to common at \$3.25 a share, then selling the preferred (anywhere between the \$2.46 Thursday close and the \$1.50 or whatever that it’s at now) would have been better than sitting on the increasingly worthless preferred. Might not that go a long way towards explaining the stock’s decline on Friday?

30. I have some basic questions:

what would happen if Citi were broken up into its natural segments?

what would happen to our country if they ceased to exist?

why do they have so much power to dictate their terms?

why are we so afraid to treat them as econoterrorists?

31. JD says:

When will the government wake up and start talking to debt???

This slow drawn out process virtually guarantees that a debt haircut is coming somewhere down the road. How much taxpayer equity will we pour in before this becomes a reality???

Perhaps we should start calling the TARP Bailout by its true and rightful name “The Great Folly”.

32. JD says:

1. Under performing segments would be sold off
2. Nothing – the world will be just fine without Citibank. If counterparty risk is minimized the vast majority of Americans would notice absolutely no effect.
3. They shouldn’t. They should be coming on their knees begging for bailout funds from the only majors investor willing to take risk at this point.
4. Not econoterrorists, simply a group of investors and individuals that made very poor investment decisions and rightfully deserve to go bankrupt if that is the final outcome. The rest of America will survive just fine without Citibank, never skipping a beat.

33. Thanks.

Then I say let’s get on with it.

34. Counterpointer says:

JD

The government will only reluctantly come round to talking about debt when the bond vigilantes render the long-note issues null and void.

Like, Wednesday.

C

35. anon says:

apologies if this has been mentioned and I missed it, but isn’t it worth noting?: “…there are all sorts of contingency agreements should Citi shareholders vote down the exchange plan. (One such contigency: Preferred stock investors will have the opportunity to buy up a capped amount of common stock for the price of a single penny per share in the event shareholders reject the original plan.)…” http://amlawdaily.typepad.com/amlawdaily/2009/02/davis-polk-cleary-sidley-hogan-gibson-dunn-all-on-citi-deal.html

36. MK says:

I also wonder if the Prince’s actions are about non-delution of his current ownership stake, without adding more money his percentage of ownership would drop to a point that he would essentially have to sway on operations. He’s basically doubling down on this initial ante.

37. Sean C says:

Make money, maybe. Lose less money, possibly.

Of course, the USG can surely exert other kinds on non-financial leverage here. I’d sure be interested to know what’s gone on in some of the darker corners of these negotiations.

38. Prof. Kwak —

I believe even if the Citi repaid the preferred stock, we would still have our warrants. The warrants are our (token) means to participate the upside.

Not that it matters, since there is unlikely to be any upside.

39. Teri says:

I don’t understand why preferred shares gain so much on Friday if the preferred shares are no long receiving dividends and the gov’t are converting them to common shares.

40. HSG at MIT says:

Hmmm…well this seems a better deal for the American people than the Thanksgiving deal that Citibank…that was such a crime.

41. i am still curious where they got \$3.25 from. Is it a good deal for US government? time will tell.

42. EB says:

Alwaleed’s alternative is to run the risk the FDIC seizes citi if things worsen, at which point as a preferred and common holder, he gets flushed. He also probably doesn’t think his pfd is worth its face amount anymore (and common worthless), so he’s already taken the loss on his investment. Anyway this way, the good prince takes a loss, but at least the govy is basically showing some mercy and keeping every other shareholder (including Alwaleed) alive. And now the government is motivated to keep Citi going, while showing reluctance to overly nationalize Citi (ie screw the remaining stockholders further), which helps motivate Alwaleed to play along. Finally, for optics, if the pfd converted at \$1/common (vs \$2.40) and forced the price down to \$1, it would be too piggish — it would kill any desire for employees to stay and scare the heck out of customers. Hogs get slaughtered, although showing restraint ended up not helping the stock.

43. jonus says: