Part of the Solution: A Brave New Bailout
Intervention in Citigroup instills investor confidence.
The difference in dilution between today's government intervention (and the Capital Purchase Program) and the interventions during the September Slaughter is 8% versus 80%.
It was enough to instill some investor confidence. This is a dramatic shift in the government's bailout policy. The total dilution that Citigroup (C) common shareholders face is approximately 8% at a weighted average price of $13.88, which is 135% above today's close. Citi shareholders will be very glad to see that day of dilution arrive.
The shift in policy began with the Capital Purchase Program, which was less punitive than many expected. The deal that the government has given Citi is even less punitive. Government officials have recognized that the severe dilution that occurred at financial firms in September left those institutions solely dependent upon the government in perpetuity for future financing. Therefore, the likelihood of the government recovering any capital invested diminishes as the companies' prospects to attract private capital in the future diminish. This latest shift now gives financial firms the opportunity to get themselves back on their feet, and thus, the government has a higher likelihood of recovering its investment.
The added benefit is that this less punitive approach mitigates investors' fears that their investment will be expropriated. Since the initial announcement of the TARP in September, we've been strong advocates of an insurance program. Such a program keeps the assets in private hands and re-establishes investor confidence in the owner.
The most significant benefit is that a small amount of capital goes a long way. The risk weighting of the assets is reduced, which frees up capital. Under Basel II, the Residential Risk Weight is 35%, Commercial is 100%, and this insured portfolio will be 20%. Like any insurance policy, the hope is that the insurance will never be needed. In this case, at 10% of the insured amount, the deductable is fairly sizable and affords additional protection to the carrier--in this case, the government.
Despite the rally in the market, the commentary surrounding this latest intervention was highlighted by derision and skepticism. All of the sudden, investors are crying out for transparency. 6 months ago, market participants were fairly content to let the Fed bury Bear Stearns' mortgage assets in Maiden Lane. The commentators questioning how Vikram Pandit can be allowed to keep his job are akin to firing a firefighter for coming back out of a burning building to get a new hose. This skepticism simply highlights that there are many non-believers out there.
From our perspective, this plan is the closest structure to what we believed would be the best way to backstop the nation's financial infrastructure. If the government persists in this course of action, it will be the one that works.
Lastly, we think it is important to note today's weakness in the Dollar and the recent strength in Gold. When the panic passes, the flight to quality bid will come out of the dollar and the record amounts of liquidity the Fed is pumping will find its way to assets.
One day does not a trend make, but the developments merit monitoring. The potential is developing that an additional leg on this rally could be prompted by a correction in the dollar. It should bring a bid back to Energy and Materials, their respective equities as well as the Equity market overall.
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