Citigroup (C) is a Buy

For the past few months I have been listening to pundits who confidently assert that Citigroup (C) is on its last breath and near either outright failure or nationalization. These fearless forecasts have generally lacked meaningful supporting data; therefore, I thought it was time for independent research that would shed light on the condition of Citigroup.

My research included a review of the income statements and balance sheets of Citi for the last 8 quarters including the recently released December 31, 2008 quarter. I also reviewed the notes to those financial statements and charts showing Citigroup's recent price history.

In conjunction with that review I also reviewed the the terms of the U.S. Treasury's October injection of $25 billion in TARP funds (TARP 1) and the more recent November injection of $20 billion in TARP funds (TARP 2). Citi issued 5% Cumulative Perpetual Preferred Stock for TARP 1 and 8% Cumulative Perpetual Preferred Stock for TARP 2. By the way, despite what Barney Frank says, Citi cannot redeem those issues for at least 3 years.

Warrants awarded to the U.S. Treasury for TARP 1 allow it to purchase 210,084,034 common shares at a per share price of $17.85. Warrants for an additional 188,501,414 common shares at a strike price of $10.61 were awarded to the U.S. Treasury for TARP 2 funds.

At the time of the TARP 2 transaction, the U.S. Government agreed to "ring-fence" $306 billion (later modified to $301 billion) of Citi loans, investments, and commitments. These assets remain on the books of Citi; however, Citi is responsible for only the first $39.5 billion loss plus 10% of any losses greater than that. Citi's total exposure on these toxic assets is therefore $65.65 billion. In return for this arrangement, Citi issued an additional $4.034 billion in 8% Preferred to the U.S. Treasury and $3.025 billion in 8% preferred to the FDIC as a "fee". Citi also issued to the U.S. Treasury a warrant for an additional 66,531,728 shares of common stock at the $10.61 strike price.

As a result of these two TARP transactions the U.S. Treasury has the right through it warrant ownership to purchase 465,117,176 shares of common stock at prices well above the current level. Exercise of those warrants would increase the equity of Citi by about $6.5 billion and the U.S. Treasury would then own less than 8% of Citi.

As of December 31, 2008 Citi had 5.45 billion shares of common stock outstanding and its equity book value was $80.1 billion. Accordingly, its book value was $14.70. This measure of equity excludes the $49.034 billion in preferred stock owned by the U.S. Treasury and the $3.025 billion in preferred stock owned by the FDIC. It also ignores the fact that Citi had $29.616 billion in its reserve for loan losses at the end of 2008 and that represented 4.26% of its outstanding loans.

The threat of a deposit run has also been taken off the table by the Federal Reserve's open discount window policy. Citi's greatest strength is that it has been under the microscope longer than any of its competitors. It has, therefore, been forced to shore up its problems earlier than other banks, which acquired severely troubled institutions like WAMU, Wachovia, Merrill Lynch, Bear Stearns, and Countrywide. Citi will likely turn the corner before these other banks.

The appointment of Richard Parsons as Chairman of the Citi Board is important given the fact that he was a member of President Obama's economic advisory team and standing alongside Paul Volcker onstage when that team of advisors was introduced.

Given all of the above, talk of nationalizing Citi is absurd. The U.S. Government has already played its cards and decided to protect all depositors. It has already bailed out Citigroup. To paraphrase Mark Twain, fear of Citigroup's imminent demise are greatly exaggerated.

Based on the above analysis, I initiated the purchase of Citigroup (C) common stock on January 26, 2008.