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Citigroup seeking to salvage its reputation

It was a big week for Citigroup last week: the bank named a new CEO and then, in an about-face, took control of the seven troubled funds it used to manage at arm's length.

Investors are viewing the two moves as steps in the right direction to restore the bank's shaken reputation, but also expect there is more to be done.

With a month to go before Citigroup Inc is expected to reveal its first quarterly loss in over a decade, investors remain uncertain how much the bank's financial muscle has atrophied amid the tight credit markets -- and what bitter pills the bank must swallow next to regain its strength.

Responding to foundering investor confidence, Citi late on Thursday said it will incorporate its seven "structure investment vehicles" (SIVs) onto its balance sheet. The SIVs have US$62 billion in assets -- or US$49 billion excluding cash and cash equivalents -- and US$58 billion in debt. Citi had previously set aside US$10 billion in liquidity aimed at keeping the SIVs operational, but Thursday's move makes Citi's obligation to the funds official.

Wall Street is relieved that under the new leadership of Vikram Pandit -- a Morgan Stanley alum who took charge of Citi's investment bank units this year -- Citi is making the major changes needed to position itself for recovery. But the bank still faces an uphill battle to restore its financial strength -- a fight that will likely require asset sales or a dividend cut.

First, Citi's Tier 1 capital ratio -- the ratio of its cash to its debt, a measure of financial strength -- is expected to fall by 0.16 percent to about 7.16 percent in the fourth quarter because of the SIV decision.

Bank of America analyst John MacDonald wrote in a note that he believes it could fall to 6.8 percent by the year's end. That's well above the 6 percent that regulators consider "well capitalized," but below Citi's peers.

Given that Citi is the largest US bank with nearly US$2.36 trillion in assets, investors are concerned.

Second, no one knows how much assets are worth right now. Citi said 54 percent of the SIV assets are rated AAA and 43 percent are rated AA, but high ratings don't instill the same sense of security they used to -- recently, a collateralized debt obligation (CDO) run by Credit Suisse was liquidated, and even the investors holding AAA notes were left with less than 25 percent of what they originally paid.

And third, Citi's exposure to bad debt through SIVs is minimal compared to the bank's holdings of CDOs. Citi has approximately US$55 billion in direct exposure to US subprime mortgages, debt that no one wants to hold right now because of the housing downturn.

Of that US$55 billion, about US$43 billion is exposure to CDOs, with mortgage- or asset-backed securities underlying them.

It is this exposure that led Citigroup to warn in October that it will need to write off as much as US$11 billion in the fourth quarter because of decaying credit quality, in addition to the US$6 billion it wrote down in the third quarter.

Because of these problems, Citi's dividend appears to be in jeopardy. The bank has said repeatedly that it plans to maintain its dividend -- but then again, Citi was just as adamant about keeping its SIVs off its balance sheet. That pledge was dropped just two days into Pandit's tenure.

CIBC World Markets analyst Meredith Whitney wrote in a client note that the SIVs on Citi's balance sheet are likely to force the bank to raise more cash by selling US$100 billion of its assets and cutting its US$0.54 quarterly dividend.
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