Sunday, March 01, 2009

GIC's Conversion from Preferred to Common Marks the Beginning of the End

In news just out, GIC has agreed to convert its preferred stake in Citigroup to Common Equity, to go along with the US government's continued bailout plan for the company.
GIC converts preferred notes in Citigroup to common shares
By May Wong, Channel NewsAsia | Posted: 27 February 2009 2026 hrs

SINGAPORE: The Government of Singapore Investment Corp (GIC) has said it will convert its convertible preferred notes in the US lender Citigroup to common stock in a bid to help shore up the troubled US lender.

The exchange price is US$3.25 a share – a 32 per cent premium to Citigroup's closing price on Thursday. The price is way under the conversion price of US$26.35 a share under the original terms of the investment.

With the conversion, GIC's stake in Citigroup will rise to an estimated 11.1 per cent, without any injection of additional funds.

In January 2008, the Singapore sovereign wealth fund bought about US$6.88 billion worth of perpetual, convertible notes in Citigroup. These preferred stocks would pay a 7 per cent annual dividend.

In the deal between the US Government, Citigroup, and Citi's other preferred shareholders, the US government will take up to a 36% stake the company. The Business Times has a very positive take on the issue, saying that:
GIC cuts loss in one fell swoop
Conversion of its Citigroup preferred shares into common stock will pare paper loss from US$5.5 billion to US$1.67 billion - By CONRAD TAN

THE Government of Singapore Investment Corp (GIC) will convert all its preferred shares in Citigroup into common stock to cut its losses. The swop will give it an 11.1 per cent stake in the troubled US bank, which yesterday announced a sweeping plan to boost its common equity base. The conversion will pare GIC's paper loss on its original US$6.88 billion investment in Citi from 80 per cent or US$5.5 billion to 24 per cent, or US$1.67 billion, based on Thursday's closing price of US$2.46 for Citi shares.

Personally, however, I think this conversion of preferred to common signifies the beginning of the end for GIC's investment in Citigroup. The best case scenario for GIC was actually to retain its preferred stake and to continue to receive the 7% dividend on its stake. This would be a gauranteed stream of dividends, as long as Citigroup did not default on its scheduled payments. But the conversion of GIC's stake signifies that Citigroup is not in a position of financial strength that enables it to meet its preferred payments.

But this is extremely alarming. If Citi is not able to meet its preferred payments, that means payments to its more senior creditors are at risk. Obligations to common and preferred shareholders represent only a tiny minority of the bank's liabilities - the vast majority of its obligations are in the form of deposits and debt. And the reason why the default on its preferred payments is alarming means that default on its payments to bondholders is just over the horizon. And once this happens, Citigroup is basically headed for bankruptcy.

The following extract from institutional risk analytics - explains this very well:
the Q1 2009 numbers at Citigroup (NYSE:C), Bank of America (NYSE:BAC) and JPMorgan (NYSE:JPM) are going to make clear, even to members of the Obama Administration, that talking about injecting new equity into the largest banks without first resolving these institutions is a waste of time and money.

Remembering that half of the liabilities of C, BAC and JPM are funded out of the bond markets and not via deposits, it should be clear to one and all that the US taxpayers are not in a position to subsidize the bond holders of these three banks, representing some $1.5 trillion in debt, if the deposits of these banks are to be protected. Some people, indeed, many people believe that we must avoid another Lehman Brothers type resolution where bondholders take a loss, but to us the only scenario where depositors of C, BAC, JPM do not take a loss is if we haircut the bond holders.

There are no easy answers here, but the guiding principle left by the Founders that bankruptcy be used to quickly and finally resolve insolvency is instructive. In that sense, Lehman Brothers is the ideal example, not something to be avoided. The model of the conduct of the Lehman liquidation by the US Trustee is an excellent archetype that should be carefully studied and considered as the Obama Administration considers the next move. If we are going to consider a restructuring for General Motors (NYSE:GM) and what remains of Chrysler, then Washington better be in a position to talk with finality about resolving the big banks at the same press conference.

What is required in Washington is an adult conversation, between the US government on the one hand and the holders of the bonds of the largest banks on the other. Many of the bond holders of the large banks are foreign governments, central banks and investment funds and not a few of these sovereign names are in really serious financial difficulties. Since the receiverships for Lehman Brothers and Washington Mutual, where bond holders took a near total loss, these foreign investors have been vocal in demanding that US taxpayers protect them from further harm.

But to deflect these cowardly, expedient arguments, the US government must be willing to lead by example to show that there really is only one way to restore confidence in zombie banks: use receivership to wipe out the common and preferred shareholders, conserve the deposits and sell the good assets to new investors, and then restructure the remaining operations of the bank to maximize recovery to the bond holders and other creditors.

Bernanke has come out on the record as saying that nationalisation is off the table. Other US politicians who initially played the nationalisation card have retracted the argument. Given that the list of bondholders and biggest shareholders of Citigroup are foreign governments and sovereign wealth funds like GIC, it all makes sense now that those comments by Bernanke are mostly politically driven.

Bernanke knows that at the end of the day and restructuring and recapitalisation of Citigroup will be inevitable. But he is trying to make it an orderly process and one that is politically palateable to foreign investors. And so, I really wouldn't be much comforted by the illusion that GIC has cut its losses in "one fell swoop." As a Singaporean, I'd be well prepared that our stake would eventually be wiped out.

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