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Sunday, March 01, 2009


death by a thousand debt-to-equity cuts

tim geithner's treasury last week set out a rather compromised plan to recapitalize citi without contributing a dime of taxpayer funds. the idea was to 'incentivize' preferred shareholders to convert to common equity by offering to match up to $25bn of such conversions out of its own preferred, $45bn of which was acquired in an earlier incarnation of the ongoing rescue.

full conversion would render the existing common diluted 74%, and the net effect on friday was to slay C common (and drag along BAC as well). the mechanics may have been misinterpreted by wall street, as noted by henry blodget, and there could be some reversion monday.

there's some question as to why investors would bother to trade down the capital structure in a bank as damaged as citi is. but the truth likely is that investors understand that preferred and common alike would be worthless in a resolution -- there's likely no relative advantage to being anywhere in the structure south of the senior debt. the upside is a vague hope of lightening the debt burden on C enough to eke it through the crisis, should things miraculously turn around soon.

things won't, of course. as noted at option armageddon, C's assets are falling apart and will keep disintegrating for some time. but C suspended the dividend on the preferred, so what's the harm? and geithner is anyway surely cajoling behind the scenes, rattling the sabre of outright seizure.

zero hedge weighs in with an interesting observation on nervous holders of C hybrid convertibles and an extrapolation outlining how banks like C and BAC may be recapitalized incrementally by repeating this process, stepping further and further up the structure, until eventually even the senior debt is restructured and swapped at least in part for equity -- but never wiping the initial equity properly as would be done in an FDIC resolution, thereby never having the bank actually fail.

Ironically, instead of waiting to see the notes thru their conversion, the fund may decide to convert early making a potential full-blown nationalization even more politically charged, due to ADIA's extended web of investments in a plethora of U.S. companies and GSEs. The last thing Geithner can afford is to anger such a huge investing partner as ADIA, and by implication it neighboring sovereign wealth funds of countries such as Kuwait, Qatar, Dubai, and Saudi Arabia .... The real concern should be for other convertible (and potentially higher up in the capital structure securities), who unlike ADIA can ill afford to lose out on their heretofore considered safe investments.

"We know ADIA is following the recent developments closely, but as a bondholder, ADIA's investments are secure because the U.S. government has left bond holders untouched, unlike other investors such as preferred shareholders," a senior Abu Dhabi-based banker close to ADIA said."

However, it is early days, and we need to wait and see what ramifications the latest events would have and whether there would be pressure on investors in bonds to convert (early)," he said.

Citi, he said, has been urging preferred shareholders and convertible bond holders to convert to common stock to help avoid nationalization by the U.S. government.

Indeed, what is becoming more and more obvious, is that while the government is unlikely to wipe out the common stock tranche in Citi and other banks ever (which would be de facto nationalization and by implication a failure of a "too big to fail" bank, which Geithner will simply not allow per Lehman bankruptcy consequences), it will continue a forced creeping dilution of higher and higher tranches of the balance sheet into Citi common stock. Yesterday the preferred, today the convertible stock, tomorrow unsecured and lastly secured bonds. At some point the common may actually be worth something fundamentally, regardless of squeezes and other contraptions. We can only hope in the process Geithner does not royally anger someone really important along the way as it forces them to convert into a chunk of more and more diluted common stock.

in some ways, this is merely a delaying tactic. if eventually senior debt will be restructured, why not get it over with before zombie banks wreak more havoc upon the economy? such has been the rallying cry of take-our-medicine crowd, which often includes yours truly.

but these are, as pointed out above, political decisions with potentially severe global ramifications for the financial system and beyond. the united states is not in a position to dictate terms and alienate sovereign investors, desiring as badly as it does the aid and assistance of international capital. often times, the wisest political choice can be engaging to delay -- it can be distinctly advantageous when conditions are expected to migrate to a place where your ends are more obviously the most agreeable ends. if senior bank holding company debtholders today do not accept the precarious nature of their investments, perhaps in a year's time -- with the deeper collapse of the global economy and as the profundity of C's insolvency becomes ever more undeniable -- they will. and if that can be agreed at some future date without hazarding a lehmanesque collapse and run on the core of the global payments system embodied in these money center banks, that would seem to be a preferable choice for treasury and the government when compared to the open wealth transfers that have characterized bailout schemes to date. particularly so if they consider much higher unemployment and broader civil disorder to be a high probability in coming days.

the cost, however, would be in the economic tradeoff -- such a plan does mean sustaining very large, very weak, gradually deleveraging banks for the foreseeable future in an environment where they will -- as was pointed out by warren buffett in his letter -- be drawing the lowest cost of funding in the marketplace and crowding out some better businesses. in other words, it's a variation on a japanese theme.

UPDATE: zero hedge forwards gimme credit on C.

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