Citigroup - Gov't Rescue: Equity Moderate, Fixed Income Positive

•Citi and the U.S. government fashioned a rescue that is a positive for the company and has broader benefits for financial markets and the economy, in our view. Fixed income investors are maintained whole, which should help getting debt investors out of their shells post the Lehman bankruptcy. The U.S. is providing insurance on the tail risk on $306 bil. of high-risk assets and investing in Citi preferred stock. The rescue results in midteens EPS dilution in 2010, sizable but less than feared. When Citi redeems the preferreds, it could do so later, after the cycle has turned, and limit additional dilution as it would also eliminate expensive preferred dividends. Citi’s town hall last week triggered a significant large decline and further wave of short selling that brought the company to the brink. Stabilization of Citi is a critical step as a failure may have further seriously damaged consumer confidence and created panic globally.

• Citi issuing two series of preferred stock totaling $27 bil. ($20 bil. to boost capital and $7 bil. as a fee for the insurance) and $2.7 bil. warrants ($10.61 strike price). Citi will bear the first $29 bil. in losses (over existing reserves for these loans) and 10% of any additional losses. Many details remain unknown, such as which loans and securities will be included in the covered assets and the amount of reserves against these assets. The assets will also be transferred with any hedges in place.

• The deal is 16% dilutive in 2010 on an economic basis due to the preferred dividends, share impact from warrants, and amortization of the $3.5 bil. discount for the $7 bil. preferreds issued as part of the deal. On a GAAP basis (assuming the warrants are out of the money) the deal is 13% dilutive in 2010.

• Dilution from future common equity issuance could be low depending on Citi’s valuation. We do not expect Citi to issue common stock until earnings have recovered materially. If Citi issues stock after 3 years and earns $2-3 per share by 2012, additional EPS dilution could be about 3-5% even if Citi trades at 8-10x P/E.

• Fixed income markets reacted positively to the bailout with sharp improvement in ABX, MBS spreads, and Citi CDS spreads (which fell by half, i.e., tightened 250 bp to levels of one week ago, before the town hall). Citi management chose to pursue the government rescue option rather than try to sell a sizable attractive business in a weak market and reduce some of the long-term strategic value. Citi already has some divestitures in negotiation but not yet announced and two that are pending closure.