Citigroup, Merrill seek more foreign capital infusions

Citigroup, Merrill Seek
More Foreign Capital

Moves, Foreshadowing
Further Write-Downs,
Raise Regulatory Issues

By David Enrich, Randall Smith, and Damian Paletta
The Wall Street Journal
Thursday, January 10, 2008

Two of the biggest names on Wall Street are going hat in hand, again, to foreign investors.

Citigroup Inc. and Merrill Lynch & Co., two companies that just named new chief executives after being burned by the troubles in the U.S. housing market, recently raised billions of dollars from outside investors. Now they are in discussions to get additional infusions of capital from investors, primarily foreign governments.

Merrill is expected to get $3 billion to $4 billion, much of it from a Middle Eastern government investment fund. Citi could get as much as $10 billion, likely all from foreign governments.

Such large investments would be the latest sign big banks are undergoing a rapid recapitalization to stabilize their shaky financial foundations. Already, foreign governments have invested about $27 billion in Merrill, Citi, UBS AG and Morgan Stanley.

The new investments are sure to complicate the so-far successful efforts of Wall Street firms to keep these purchases below the Washington radar screen. Multiple investments from government funds will get closer scrutiny from regulators for signs the funds could work together and exercise control. Any questions will lengthen the time regulators need to review the deals. And federal lawmakers, who've given the string of government investments a pass, will take another look in this election year.

"The goal is to get a [page] B6 story in the Wall Street Journal and have no one mention it," said a Washington lobbyist who has shepherded a number of foreign-government investments in Wall Street through Congress.

In addition, shareholders may not take too kindly to transactions that, while bolstering the capital base, dilute existing shareholders because of the issuance of additional shares.

Their grousing is offset in part by a salubrious effect on the larger economy: It's better for capital-short banks to raise money from investors than to sell assets and cut back on lending -- thereby spreading the credit crunch from Wall Street to Main Street.

Both Citi and Merrill are scrambling to nail down the details before they report earnings next week that are expected to include additional losses stemming from their exposure to mortgage-related investments. Together, these additional losses could reach as much as $25 billion.

The board of Citigroup is expected to meet on Monday, a day before it reports earnings, and to discuss cutting the firm's hefty dividend in half. This could save more than $5 billion a year. Citigroup has repeatedly said its dividend was safe. But Vikram Pandit, its new chief executive, is seen as more willing than his predecessor to take radical steps. He also is expected to announce major layoffs.

Spokeswomen for both Citigroup and Merrill declined to comment.

Coming just weeks after Citigroup and Merrill first turned to foreign governments' so-called sovereign-wealth funds, the second round of capital-raising shows that the credit crisis isn't yet abating. As the write-downs mount, other financial firms may also be seeking fresh capital.

The initial infusions were expected to quench the companies' thirst for fresh capital. But mortgage-related write-downs have continued. And Citigroup last month bailed out seven affiliated investment entities, bringing onto its balance sheet $49 billion in new assets and further eroding its capital position.

More bad news for banks could be around the corner. With the economy weakening, Citigroup and its peers are bracing for a new round of problems stemming from souring loans to consumers and businesses. Banks' profit margins are getting pinched as they increase rates to lure depositors.

The risk of credit downgrades to bond insurers could further imperil banks that have hedged their exposure to billions of dollars of bonds by buying insurance. The value of that insurance diminishes if the insurers are downgraded, making the bonds they have on their books fall in value.

The timing appears right to tap the government funds, which are flush with cash and are actively seeking investment opportunities. That could explain the urgency with which Citi's and Merrill's new chief executives are moving to shore up the institutions, which have been hobbled by shoddy risk management and bad mortgage bets.

Mr. Pandit, once at Morgan Stanley, joined Citigroup in July and was tapped as CEO last month, after the resignation of Charles Prince. The same month, John Thain, who had been running the New York Stock Exchange, took over at Merrill, weeks after the ouster of Stan O'Neal.

Mr. Thain quickly sold up to $5 billon in Merrill stock to Temasek Holdings Pte. Ltd., an investment company owned by Singapore's government. He also sold $1.2 billion of Merrill stock to a mutual-fund manager, Davis Selected Advisers LP. At $48 a share, the sales came at a hefty discount to Merrill's market price then of around $54. Mr. Thain also recently sold most of Merrill's commercial-lending unit.

Merrill is expected to announce this month the departure of co-president Ahmass Fakahany; he had backed the appointment in 2006 of the bond executives who oversaw the mortgage-asset positions that caused the losses. That would put Gregory Fleming, a respected investment banker, as the sole president and clear No. 2 unless Mr. Thain promotes someone else.

....Clean Slates

Both new CEOs are hoping to put mortgage-related losses behind them and start their tenures with clean slates. By refilling the coffers, capital injections offer an opportunity for "the business equivalent of the do-over," said Brian Posner, chief executive of ClearBridge Advisors, a money-management unit of Legg Mason Inc.

Do-overs, though, are proving somewhat messy from a regulatory and political perspective, since they involve foreign governments.

Abu Dhabi's investment arm invested $7.5 billion in Citigroup in late November, gaining a 4.9% stake. Merrill received $5.6 billion for a roughly 12% stake, though Temasek's stake will stay below 10%.

This time around, Merrill is expected to tap the Middle East, and Citi may tap the Middle East and Asia. One possible source for fresh capital for Citigroup could be the Government of Singapore Investment Corp., or GIC. Mr. Pandit already has a relationship with the fund, which was one of the original investors in Old Lane Partners, a hedge fund that he co-founded and that Citigroup bought last year.

A patchwork of regulations and statutes involving banks makes outside investments particularly tricky.

For example, deals that leave a single investor owning 5% or more of a bank's shares can trigger regulatory scrutiny under the Bank Holding Company Act. While the Federal Reserve in the past has permitted some transactions that exceed that 5% threshold, the Fed also could subject the investor to periodic examinations or require it to maintain certain capital levels. Major funds are loath to open their books to regulators, and tying up their capital to meet regulatory requirements would prevent them from deploying it in more lucrative fashion. (The issue doesn't arise with Temasek's Merrill investment because Merrill isn't a commercial bank.)

For stakes of more than 10%, or if the outside investor would be represented on the bank's board, the regulatory hurdles become even more cumbersome. The Fed, along with the Treasury Department, also can investigate whether the investors planned to exercise coordinated control of the company.

As a result, financial institutions -- including Citigroup in its Abu Dhabi deal -- have taken pains to avoid the different regulatory thresholds that would attract more scrutiny.

"They negotiate the contracts in light of the regulatory regime in the United States," said Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics who has held top posts at the Fed and Treasury Department. "It's not an accident you get 9.9% and 4.9% and things like that. They are negotiating in the shadow of the Bank Holding Company Act."

Still, banking lawyers say it's possible to arrange major infusions without running into regulatory interference. Under one theory, sovereign-wealth funds should be regarded as government entities, not companies or investors -- and therefore the Bank Holding Company Act and other laws wouldn't apply in the same fashion.

...Political Risk

Another risk is political. Lawmakers could try to force the investors to submit to more scrutiny by the Committee on Foreign Investment in the U.S., an interagency group led by the Treasury Secretary.

Typically, passive investments of less than 10% in a U.S. company by a foreign firm wouldn't require a review by the interagency group. But agitated lawmakers could clamor for one and delay a time-sensitive deal. Before Citi announced its capital infusion from Abu Dhabi, the company briefed select lawmakers to assuage potential concerns. When the deal was announced, key lawmakers were either supportive or mum.

The issue is likely to gain more scrutiny this year. Senate Banking Committee Chairman Christopher Dodd is expected to hold hearings on the matter soon, as some lawmakers have raised questions about a lack of transparency in the investors.

The Bush administration has so far been welcoming of these infusions. "I'm fine with capital coming in from overseas to help bolster financial institutions," President Bush said at a news conference in December. "I don't think it's a problem. I think what will be a problem is to say we're not going to accept foreign capital, or we're not going to open markets, or we become protectionists."

Given the sensitivities, the banks are talking to multiple investors to see that no individual investor gets too large a stake, so as not to alarm politicians and regulators.

...Shareholder Concerns

Their own shareholders, though, have had mixed feelings about these outside investments. In the weeks since the Citigroup and Merrill deals, the companies' stock prices have skidded, along with other financial stocks. Yesterday, they benefited from a slight rebound in the overall market, with Merrill up nearly 5%, or $2.31, to $50.48 a share, and Citi up 35 cents to $27.49.

Shareholders "view this as the kind of capital you raise in extremis," said Brad Hintz, an analyst at Sanford C. Bernstein. Merrill's stock declined on the news of its last infusion, he said, because the sale of new Merrill shares to Temasek and the mutual-fund firm diluted existing shareholders. Citigroup's shares also declined modestly following its Abu Dhabi deal.

Also hurting the stocks are ballooning estimates of both banks' fourth-quarter write-downs.

Merrill's fourth-quarter results, to be announced Thursday of next week, are expected to include a new write-down of roughly $10 billion, analysts predict, on mortgage-related investments such as collateralized debt obligations. These caused a hit of $7.9 billion in the third quarter, which far exceeded previous estimates. Such a new write-down could make Merrill's losses the biggest on Wall Street.

Citigroup on Tuesday may report up to $15 billion in mortgage-related losses. That would eclipse the up to $11 billion that Citigroup has warned it might have to write down. And it would far exceed the third-quarter $2.2 billion write-down. Adding to Citigroup's suffering, the weakening U.S. economy is likely to mean mounting losses on consumer loans.

The third-quarter losses, coming on top of some costly acquisitions, pushed Citigroup's capital level -- a key measure of the bank's ability to absorb sudden losses -- below its internal targets. The bank said it would stop repurchasing its own shares until its capital is restored.

But analysts and investors say that even with Abu Dhabi's investment, the looming fourth-quarter write-downs mean Citigroup will need to find billions of dollars in new capital -- or shed billions of dollars in assets -- to meet its goal of replenishing its capital by this summer.

Messrs. Pandit and Thain are confronting other painful decisions as well. For Citi, a dividend cut could be particularly embarrassing, given assurances in recent months that the dividend was safe. Industry experts say it has become more palatable for Citigroup to cut the dividend following similar actions by other financial institutions, including, most recently, National City Corp., a regional bank based in Cleveland.

"Others have done it, so ... I don't think it would catch anybody by surprise," said Lee Delaporte, director of research at Dreman Value Management LLC, which owns Citigroup shares.

A major cost-cutting initiative also is under way, in which Citigroup could reduce its global workforce of more than 300,000 by as much as 10%. In addition, executives are working on plans to sell business lines in the U.S. and overseas in order to free up capital.

Slumping stock prices have hurt morale at both companies, where bankers and other executives' pay packages typically include big chunks of stock.

...Employee Exodus

Merrill, possibly hoping to avert an employee exodus, is expected to accelerate some stock awards to employees, said Mr. Hintz, the Bernstein analyst. This would put more cash in employees' pockets at a time when many year-end bonuses will be smaller because of the losses. It would also add to the firm's book-value equity capital, Mr. Hintz indicated.

At Citigroup, though, bonuses could be the latest casualty of the credit crunch. When they're handed out later this month, year-end awards are expected to consist mostly of stock, a shift from past practice.

Mr. Hintz said infusions from outside investors often are structured as "immediate capital," both to meet regulatory requirements and to reassure credit-rating agencies about the impact of write-downs as they are being taken. Such reassurance may forestall a downgrade that could boost a financial firm's cost of doing business or reduce vital access to credit. In addition, the deals can permit companies to avoid selling valuable assets or withdrawing from some markets, moves that risk damaging the franchise, Mr. Hintz said.

Some investors have taken a stoic attitude toward the possibility of future cash infusions that dilute their holdings. "At the end of the day, it isn't what anybody would want to happen, but there aren't a lot of alternatives," said Mr. Delaporte of Dreman Value Management.

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