Monday, March 2, 2009

What is Tangible Common Equity and Does More Make Citigroup Safer?

By Christopher Whalen (Institutional Risk Analyst):

With the imbroglio last week regarding the conversion of preferred equity in C into common to provide some superficial relief regarding the banks levels of tangible common equity, we asked our friend Bert Ely of Ely & Co. to describe the difference between TCE and regulatory capital measures.

"TCE -- tangible common equity -- is an unofficial term which has gained great prominence in recent months. As I understand it, TCE is simply the GAAP book value of common equity minus goodwill and possibly minus other intangible assets. Therefore, the TCE ratio would be TCE divided by total assets minus whatever intangible assets were subtracted from common equity in calculating TCE," says Ely.

"Tier 1 capital is a regulatory capital definition that varies from country to country and includes a number of pluses and minuses to equity capital. This FDIC worksheet is a good example as any of the calculation of Tier 1 capital:

"TCE essentially is a leverage ratio, albeit a conservative one. It will be interesting to see the extent to which this market-driven capital measure overwhelms various regulatory measures of bank capital," Ely concludes.

Last week, when C announced that the US government and several preferred equity holders were converting to common, few were fooled by this obvious canard to bolster TCE without increasing actual capital. Citi also seems a bit sneaky on their presentation. They show TCE as a % of Risk Weighted Assets as opposed to Tangible Assets. The latter nets out the goodwill as with TCE, but RWA is far smaller and would tend to make the TCE look bigger.

In the case of Citibank NA, for example, at the end of 2008 Risk Weighted Assets ("RWA") was $713 billion vs. $1.231 trillion in total assets and some $900 billion in tangible assets. Or to put it another way, RWA was 57% of total assets at Citibank, so obviously dividing the TCE by the smaller RWA gives you a better capital ratio. You'd be surprised how few people actually noticed this last week.

It is very telling that the regulatory "definition" for the stress testing of TCE will also use RWA in denominator, the latest evidence that nobody at the Fed's Board of Governors understands safety and soundness benchmarking. Just for the record, we'll provide a complete set of our stress test results to the Treasury if they so request. But they have to pay for it like anybody else.

In 2007, C reported over $40 billion in intangibles, which dropped to $27 billion at the end of 2008. The firm's TCE to tangible assets is an abysmally low 1.4%. If you use the low side of their estimate of preferred conversion (i.e., $12.5 (committed) and $12.5 UST), this gets them to a TCE of around 2.55%, still too low, IOHO, and not enough to withstand stress.

If high side pricing for the C preferred converts strikes your fancy, then TCE is 3.8% - maybe enough, but we feel they are likely to go to undercapitalized in the severe stress case that seems likely for the US economy in 2009. And don't forget we still have another $27 billion in goodwill, deferred tax assets and other intangibles to deal with going forward.

Bottom line: The US government is collecting a fine group of Zombies. Fannie Mae, Freddie Mac, American International Group (NYSE:AIG) and Citigroup. These zombies don't eat people, they eat money. And as 2009 proceeds, the amount of money that these Zombies eat is going to grow until the Obama Administration is going to be forced to do the right thing, at least with AIG and C, and put these two zombies into a restructuring and place their regulated entities under conservatorship. More on precisely how to do that in our next issue.

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