The US government and Citigroup

I’ve been getting some good questions from clients lately that I will answer for everyone, since if one person is asking it, many more are probably thinking it. Today, someone asked what the US government’s new deal with Citigroup means, and whether it makes the stock a “buy” now.

Today, the government announced that it is converting some of the preferred shares that it acquired in 2 prior investments into common stock. As you should know, common stock (or “equity”) represents a “residual claim” on a company. This means that if the company goes under, everyone else gets paid ahead of the common shareholders. If the company grows, the common shareholders get most or all of the benefit.

Preferred stock, despite its name, functions more like debt: the holders are paid a fixed rate of interest and do not get additional financial rewards if the company grows. The difference between preferred stock and more conventional debt (such as bonds) is that preferred stock comes next in line in case of a bankruptcy, but still ahead of common stock. It also is typically “perpetual,” meaning it never matures (unlike a bond, which has a fixed term of years).

When the government initially invested in Citigroup and other banks, it bought preferred stock that paid a fairly high dividend (8% in the case of Citigroup). It has now agreed to convert up to $25 billion of those shares into common stock, provided that private investors who also own preferred shares agree to convert a similar amount. As of today, it looks like $27.2 billion of privately-held preferred shares will be converted, thus exchanging a total of $52.2 billion of preferred stock for common equity.

What this means for Citigroup: First, the company will save about $4 billion per year in preferred dividends (its annual common stock dividend is only $.04 per share). Second, Citigroup’s balance sheet now looks considerably different, with $52.2 billion more in common equity and that much less debt, giving it much more headroom to sustain losses in the future without putting its survival in peril. This has happened without any additional investment of cash by the government or private investors, and represents yet another move by the government to keep Citigroup from going under.

What it means to the US taxpayer: The government (and thus all of us) will now own a total of 36% of Citigroup. Our $25 billion investment will now bear the same risk as all the other common shareholders: if Citigroup goes under, that $25 billion will disappear. This obviously gives the government even more incentive to keep Citigroup afloat. On the flipside, if the company eventually recovers, taxpayers stand to make a lot of money.

What it means to current Citigroup common shareholders: They will be “diluted” by the issuance of a lot of new shares, reducing their stake in the company from 100% to only 26%. This is probably the main reason that Citigroup’s stock fell so much today, as the existing shares now represent roughly 1/4 as much ownership as before. On the other hand, 1/4 of a company that survives and may eventually thrive is worth more than 100% of a company that goes under.

What this means for the financial system and other big banks: For the financial system as a whole, this is a good thing because letting a bank the size of Citigroup fail would make a bad situation even worse. It also sends a clear message that the government intends to rescue all the big banks, but will avoid fully nationalizing them.

On the other hand, there are 3 real concerns here:
1. Will the government need to put in more money later, after Citigroup’s “stress test,” and potentially gain even more ownership, further diluting existing shareholders? (I suspect that any additional funds will be invested via preferred shares that don’t convert.)
2. Will the government need to convert preferred shares in other big banks, such as Bank of America, and thus end up with significant ownership in several big banks?
3. Will Citigroup have an unfair competitive advantage over other banks as a result of its actual or implied government guarantee?

Until these questions are more fully answered, expect the market, and bank stocks in particular, to continue to be volatile.

So does all this make Citigroup a “buy” or a “sell?” It’s pretty clear to me that the bank is not going to fail, but it could be broken up by the government, and existing shareholders could be further diluted. This makes its shares, even at their current price of $1.50, very risky. On the other hand, if things eventually work out for Citigroup, they could easily soar 10 or 20 times. So they make an attractive speculation, but no more than a speculation. As of today, I’m still staying away from these shares with so many other juicy, but safer, opportunities.

Next up: Is the stock market’s price/earnings ratio high or low? Are stocks really cheap or do they just appear to be?

Enjoy your weekend

Why it's risky to sell now

It sounds counterintuitive, but it may actually be riskier to sell now than to stay fully invested. This would be true even if the bear market still has many months to go. Why? Because of bear market (or “countertrend”) rallies, which tend to be both rapid and powerful. They also tend to be unexpected, seemingly coming out of nowhere when both news and sentiment are terrible. Kind of like now.

How powerful are these rallies? Very. Look at Japan since 1989, when its stock market last peaked. Since then, it’s been in a secular downtrend that’s lasted 19 years so far. There have been 7 countertrend rallies during that time, ranging from +21% to +135%, with a median gain of +48%. On average, 1/5 of that gain came in the first 5 days, so its pretty hard to just jump in when it starts. Each one lasted several weeks to a many months.

The picture in the US is similar. During the secular bear markets of 1929–1938, 1966–1980 and 2000–today, there have been 8 countertrend rallies. They median gain was +67%, even better than in Japan, with 1/5 of the rise coming in the first 13 days.

So big rallies do happen during extended bear markets, and we have yet to have one since the current downtrend began in late 2007. When it finally arrives, suddenly and without warning, it should be impressive. The question at that point will be: Is this a countertrend rally or a new bull market?

Unfortunately, it’s usually almost impossible to tell until well after the fact. But fortunately, it really doesn’t matter for most investors. If you are invested for the long term, you should stay that way during and after the rally. If you need to reduce the risk level of your portfolio, you’ll want to cut back on your equity holdings after they’ve recovered somewhat regardless of what you think the future holds. This is good, since the future is ultimately unknowable. The only thing I know for sure is that it won’t look like the past.