Citi & Morgan: Having Fun Yet?

Late last week, Citigroup, Inc. (C - Analyst Report) announced it was in talks to spin-off its Smith Barney brokerage unit into a joint venture with Morgan Stanley (MS - Snapshot Report). As the deal is currently proposed, Morgan Stanley would pay $2.5 billion to Citigroup for Smith Barney, creating the world's largest brokerage firm with nearly 20,000 brokers (before layoffs and other overlap reductions).

This deal is an attempt by Citigroup to raise capital and minimize 1Q09-quarter losses. In addition, Citigroup could look to "write-up" its books by much as $10 billion from the sale of Smith Barney. We suspect other units of Citigroup could be up for spin-off or joint venture discussions as well.

The anticipated synergies associated the ability for Citigroup to "cross-sell" a broad range of financial products to its customers appears to have not materialized in application. We suspect that this joint venture has the potential to evolve into an eventual stand-alone entity. If this were to occur, it would mark the return of a major independent brokerage house, which had all vanished over the past ten years -- the result of acquisitions by commercial and investment banks seeking greater diversification.

It would appear the Federal Government was putting pressure on Citigroup to make changes. If the venture were to be completed, it would add additional capital to the beleaguered institution, which has had $20 billion in losses over the past year due to the credit crisis and recession. So far, the Federal government has pumped approximately $300 billion in federal bailout funds ($45 billion in direct capital and approximately $250 billion in guarantees for toxic debt), which appears not to be enough to cover Citigroup's current issues.

At this time, we would also expect the company to be developing a "Good Bank/Bad Bank" scenario, which would create a separate entity for loans and other troubled assets to be worked through, thereby improving the appearance of Citigroup's balance sheet. This approach did work during the last credit crisis.

In our opinion, management should also look to raise additional capital by forgoing salaries and bonuses for the next two years (as they were ultimately responsible for the current debacle) and focus on developing the above scenario. Salaries and bonuses could be reinstalled sooner, but not retroactively, if the "Bad Bank" scenario were to be worked-out to some significant level of the original agreement were to be recovered (perhaps 75-85%).