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Thursday, March 28, 2024

Citigroup Arithmetic Explained

Undoing the confusion on the Citigroup bailout, James Kwak explains the details in the numbers.

Citigroup Arithmetic Explained

Courtesy of The Baseline Scenario, by James Kwak

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.

Additional note by James Kwak in the comments section:
 
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.
 
James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School.  He is a co-founder of The Baseline Scenario.
 
 
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