FYI | Nov 28 2007
By Greg Peel
If US mortgage lender Countrywide had become the bellwether stock for what was once simply known as the “US subprime crisis”, Citigroup had since become a bellwether for the resultant “global credit crisis”. America’s largest bank has seen its shares lose over 40% of their value in just six months, falling to below US$30 per share for the first time since the depth of the tech wreck market in 2002.
At last count Citi was still looking at a total of some US$11 billion in credit security write-downs, although numbers as high as US$15 billion have been touted by analysts. Despite management assertions to the contrary, the extent of the losses was seen to put the bank’s capital adequacy in jeopardy, and prompted predictions of a cut in its dividend. A bank’s dividend is its holy grail, given a financial institution deals only in the generation of profit from moving money around between those who have it and those who don’t. If a mining stock cuts its dividend, for example, it’s not the end of the world. If a bank cuts its dividend it means serious trouble.
Earlier this month CIBC banking analyst Meredith Whitney downgraded Citi to Sell (Goldman Sachs was later to do the same) suggesting the future looked so bleak the bank would need to raise US$30 billion to avoid cutting its dividend, or may even have to do both. Whitney received death threats for her troubles. Another popular suggestion was that Citi, which had turned into an underperforming unwieldy conglomerate under the management of since departed CEO Chuck Prince, would need to be broken up and sold off separately. The Citi board had always quashed such rumours, hinting at a capital restoration solution that would set all to right without much trouble.
Had Citi attempted to raise equity capital in the current environment through, for example, a rights issue, it would have been forced to offer a significant discount simply to perk anyone’s interest. The more prudent solution was to scour the world for someone who was keen to take a longer term interest in the bank, and do so at a reasonable price. The obvious place to go was thus the Middle East – a region overflowing with petrodollars – and the biggie of them all is Abu Dhabi and its world-beating US$1 trillion sovereign wealth fund – the Abu Dhabi Investment Authority (ADIA).
Citi is not a newcomer to Arab investment. A longstanding investor has been Prince Alwaleed bin Talal bin Abdul Aziz al Saud of Saudi Arabia, with a 3.6% stake. When Citi was looking to ditch its CEO last month, Prince Etc summoned one or two executives across the ocean for a fireside chat (perhaps without the fire). Nor has the ADIA been alone in its perusal of Citi as an investment. The equivalent Investment Corporation of Dubai had a look at both Citi and Merrill Lynch last week, but deemed them both to be yet too expensive.
Not so the ADIA.
“We see in Citi a highly respected company with a premier brand and with tremendous opportunities for growth,” said ADIA managing director Sheikh Ahmed bin Zayed al Nahayan in a statement. “This investment reflects our confidence in Citi’s potential to build shareholder value.” (Dow Jones)
The investment in question is a 4.9% stake at the cost of US$7.5 billion. The stake comes in the form of convertible stock with an 11% coupon (dividend). It must be converted into ordinary stock between March 2010 and September 2011 at a price between US$31.83 and US$37.24. Citi’s shares closed last night at US$30.32. The holding comes with no extraordinary voting rights or any management position. It is thus “silent”.
At first glance one might look at 11% and think Holy Mother of God, America’s largest bank is having to raise capital at 600 points over Libor. But the reality is that after tax, the coupon is about equivalent to Citi’s 7.25% dividend yield. The attractiveness for Citi is the raising represents an 8-25% premium over today’s price once converted, whereas an equity raising in the market would require a hearty discount.
As the US$7.5bn represents tier 1 capital, it lifts the bank’s capital ratio to just under its target of 7.5%. This should offset the supposed US$8-11 billion of credit security write-downs due this quarter, or perhaps prevent a dividend reduction, or perhaps provide Citi with some capital to pursue an acquisition of its own and restore earnings flow.
It will not, however, allow for all three.
And that brings us to whether or not this capital raising is sufficient by itself to turn Citi around, or whether, indeed, further raisings will be needed. Meredith Whitney doesn’t think it’s anywhere near enough, retaining an Underweight rating and suggesting Citi will still need to cut its dividend and sell assets. Citi is not out of the woods. There is still no market for its distressed CDOs, and the lending business is drying up. With little in the way of strong revenues to prop it up, Citi announced on Monday it would be undergoing a strict cost cutting program. The rumour is this means at least 10% of its 320,000-strong workforce.
Nor is there any guarantee ADIA has bought into Citi at the bottom of the market. Bank of America injected supposedly company-saving funds into Countrywide in August, only to see its investment erode ever since.
But there is a bigger picture.
As the US economy has slowed, and more recently found itself in strife, the US dollar has fallen dramatically. In the meantime, oil-rich nations such as Russia and those in the Middle East, and manufacturer-to-the-world China, have built up vast reserves of foreign currency which are now looking for a home. The obvious place to spend those funds is in the US, where a friendly exchange rate and a weakened stock market throw up all sorts of opportunities. As cnbc.com puts it:
“A $7.5 billion Abu Dhabi deal to buy Citigroup shares may have created a model for acquisitions by Gulf and other emerging-market investors scouring the ruins of the US mortgage crisis for bargains.”
The thought of Arabs buying up America while the War on Terror prevails is something that might have seemed laughable not so long ago. And Communist China is still considered more of an enemy than an ally. If the same were happening prior to the credit crunch, such deals would have been met with stiff Congressional resistance. Indeed, Dubai was knocked back earlier in the year when it wanted to buy a US port facility, and China has to date found it difficult to make inroads into US oil. But things are different now – the US needs a lifeline.
Dubai’s state-owned private equity firm had already announced back in September it was looking to pick up a couple of unnamed US companies hit hard by the subprime crisis. China has already bought into US private equity firm Blackstone, and its CITIC securities has recently agreed to a US$1 billion equity swap with Bear Stearns.
And the acquisitions are not restricted to the US. Dubai’s DIFC Investments has bought into Germany’s Deutsche Bank, and is currently poking about in the US. Britain’s Barclays Bank now boasts both Chinese and Singaporean government shareholders which it solicited to join in with Barclays’ (unsuccessful) bid for Holland’s ABN Amro.
On Monday this week the US financial markets were potentially facing their darkest hour. The Dow Jones had broken down through the 10% correction level, bond yields were collapsing as investors rushed to safety, the US dollar was tanking again, oil was pushing US$100/bbl and the gold price was once again on the move. Despite the fact the potential of sovereign wealth funds has long been recognised, it took the Citi deal to really drag such funds into the spotlight. The question now is: does this thus mean all our troubles are over?
The short answer is no. One US$7.5 billion injection into Citigroup is not going to prevent the US economy from going into recession, if that’s what’s set to happen. It will not suddenly encourage investors to start buying distressed subprime CDOs. It will not save the US financial system from further write-downs or trading losses, and it certainly won’t turn the US housing market around. It may not even be enough by itself to save Citigroup.
But the point of yesterday’s deal is that they’re out there – those sovereign wealth funds with more money than they know what to do with. It may mean the US will have to give up some of its economic hegemony, and that Europe and Japan will have to fall into place as well. There is a changing of the guard from West to East. As far as the US stock market is concerned, there could still be more pain yet to come. But at least there will be predators lurking, ready to stem the tide of weakness when the time is right.
