Does Citigroup need a merger?

By BusinessWeek

You think you've got a tough job.

After Citigroup (C, news, msgs) named Vikram Pandit as chief executive officer last month, it became increasingly clear that the financial-services giant will present severe challenges to the new CEO.

The latest indication came in early December, when one research analyst said it will take years for Citigroup to recover from its billions of dollars in losses in the credit markets and that it may even need to merge with a stronger partner to mend its balance sheet.

The company's write-downs -- $6.5 billion in the third quarter and $8 billion to $11 billion in the fourth -- prompted last November's resignation of Chief Executive Officer Charles O. Prince III.

David Hendler, a senior analyst at CreditSights, said such write-downs may put Citi in "a precarious position in terms of capital levels." The result, he wrote in a research report, is that "the company could have to consider options ranging from dividend cuts to major asset/business unit sales, and/or a full-scale breakup or even potentially M&A (merger and acquisition) with a stronger bank."

• News: Citigroup taps Pandit as CEO

The strategic choices were inevitably intertwined with the CEO search. "Which course Citi takes," wrote Hendler one day ahead of the Pandit announcement, "could also hinge on who takes the top job, which it seems Citi has been having a difficult time filling."

Hendler isn't the first analyst to point out the weaknesses in Citi's capital structure. Meredith Whitney, a bank analyst with CIBC World Markets, downgraded the company's stock more than a month ago over the issue.

What's new is the question of whether Citi will remain independent.

Hendler said JPMorgan Chase (JPM, news, msgs) would be an ideal merger partner. He noted that JPMorgan CEO Jamie Dimon and other top JPMorgan executives have worked at Citi, and that JPMorgan Chase has a demonstrated capacity for pulling off large deals, such as the combination of JPMorgan and Bank One.

Still, a deal with Citi would be on a completely different scale. Even after the recent dive in its stock price, Citi's market capitalization is $173 billion. Citi wasn't immediately available for comment. JPMorgan declined to comment.

A lender of last resort

Hendler said investment bankers have floated the idea of a combination of Citi and Bank of America (BAC, news, msgs) but that such a deal may not be able to win federal regulatory approval. Bank of America and Citi would have 14% of U.S. bank deposits, well above the regulatory limit of 10%.

The elevation of Pandit caps a monthlong search to find a successor to Prince. Pandit had been head of investment banking and alternative investments at Citigroup, and he was a former president of Morgan Stanley (MS, news, msgs).

One of the key problems Pandit will face is the bank's exposure to SIVs (structured investment vehicles), off-balance-sheet investment funds that borrow in the short-term market and invest the proceeds in higher-yielding, longer-term investments such as mortgages and credit cards.

• Video: Citigroup gets a downgrade

SIVs are in trouble because the short-term markets, spooked by problems in the subprime market, seized up over the summer. That put pressure on sponsors such as Citi to act as a lender of last resort.

Hendler said that Citi isn't legally required to bail out its SIVs but that accounting pressures could force it to take write-downs anyway. Citi currently has SIV exposure of $66 billion, the largest in the banking industry.

Citi also has high exposure to collateralized debt obligations. CDOs are pools of debt that include some subprime mortgages. Its $46 billion exposure to CDOs is among the highest in the industry.

It could take Citi between 2.7 and 5.2 years to recover from the losses, Hendler estimates. That may be longer than investors are willing to wait, he said. The company's stock closed Thursday at $28.11, up 62 cents, or 2.26% for the day. It is down 49% from a 52-week high of $55.

Hendler said a deal with JPMorgan Chase would save billions of dollars and be immediately accretive to JPMorgan. "The primary driver of the merger math is the potential cost synergies of such a transaction," he said. Hendler estimates the internal rate of return on such a deal for JPMorgan would be 20%, if JPMorgan paid a 25% premium. The rate of return could move higher or lower, depending on the premium.

There's no guarantee that JPMorgan sees the same value in such a deal. CIBC's Whitney said weeks ago that Citi would need to cut its dividend, sell assets or raise capital. But she doubts JPMorgan would be tempted to acquire Citi, because the regulatory and business hurdles are too high. "No way on the JPMorgan Chase deal," she says.

Citi may very well remain independent. But reassuring investors it can do so effectively is just one of the challenges facing Pandit.

This article was reported and written by Steve Rosenbush for BusinessWeek.