I wake up Monday morning to discover that a “bold plan” has been announced. The US Treasury is pumping an additional $20 billion into Citigroup, and the Treasury and FDIC are guaranteeing $306 billion of risky loans in Citicorp’s portfolio. In exchange, the US government receives $7 billion in preferred stock and warrants for 254 million shares of Citigroup common at $10.61 per share.
We aren’t privy to all the information and my expertise is limited, but based on what’s been publicly revealed I’ll attempt to summarize the value of the deal for both the Citigroup Corporation and the U.S. government.
- The $20 billion cash injection is easy to understand.
- How much are the loan guarantees worth? All loans are “risky” in the sense that the lender faces some risk that the borrower won’t pay back the loan: that’s why the lender charges interest. That these loans have been specifically identified as “risky” means that there’s a greater-than-average likelihood that the borrowers will default. They aren’t all likely to default; rather, some higher-than-average percentage of them probably will. Ordinarily extra risk commands extra interest. But we presume that these are extraordinary loans: subprime, earning lower-than-average interest. So let’s say that the loan guarantees are worth the difference between the interest rate actually charged and the interest a high-risk loan ought to earn. How much is that? Let’s be conservative and say it’s 3%, meaning that if an additional 3% of these loans default the guarantor breaks even. So: $306 billion in guarantees × 3% risk premium = $9.2 billion is the value to Citigroup of these guarantees. In fact these guarantees could be worth a lot more if the property held as collateral by the bank securing these loans — presumably mostly houses and other buildings — turn out not to be worth in today’s real estate market what they’re valued at in Citigroup’s books. Because the government is only guaranteeing the loans and not acquiring them outright, Citigroup continues to hold the collateral. I presume this means that Citigroup can still decide when to sell these non-liquid assets and for how much. If they sell a house now, when its market value is down, then presumably this difference between book and sale value of the collateral will be written up as a loss on Citigroup’s loan. The government would then have to recoup Citigroup for the difference.
- Now the preferred Citigroup shares. The news releases say the shares are worth $7 billion. These aren’t shares currently in investors’ hands, traded on the stock exchange; they’re a new issue offered directly and exclusively to the U.S. government as part of this deal. The government is paying another $20 billion in cash to Citigroup to buy more of these preferred shares. How was the value for the preferred shares set? I don’t know, but let’s assume that they really are worth what the dealmakers say they’re worth. Why be skeptical? Well, there’s this…
- The warrants. The US government receives an assurance that it can buy Citigroup stock at $10.61 per share, whenever the government chooses to exercise its option to do so. At the time this deal was struck Citigroup shares were trading at $3.71 per share. That means the warrants are worthless. Potentially even worse, the government could decide to redeem their warrants at a loss in order to prop up the market for Citigroup stock.
To summarize: Citigroup gets $20 billion in cash, along with presumably uncollateralized loan guarantees in excess of $300 billion worth a minimum of $9.2 billion in risk premiums, for a total of $29.1 billion cash and equivalent. In exchange the U.S. government gets $7 billion in preferred Citigroup stock. That really is a bold plan. Put it this way: I’m not sure I’ve got all the facts at my disposal, but what’s been said leaves plenty of questions unanswered in my mind anyway.