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Citigroup: Let the Breakup Begin

Even before the ink was dry on the deal merging Morgan Stanley (MS) and Citigroup's brokerage operations, talk surfaced of more radical changes at Citigroup (C).

It's not known exactly what Citi, which pioneered the concept of the financial supermarket, will look like. But it's quickly becoming clear it will be a whole lot different from the institution initially conceived back in 1998 when Citicorp and Travelers Group were merged to form Citigroup. With the brokerage sold, Primerica, largely an insurance operation, is on the chopping block, according to a source familiar with the discussions. So are some of the bank's proprietary trading operations, the same ones that bulked up on the toxic real estate-related securities now making Citi's balance sheet sick.

Broadly speaking, the bank will still have consumer, commercial, and investment banking operations, according to the source. Citi will also hold on to its private bank, which caters to the mass affluent. (An announcement with explicit details isn't expected until the bank's earnings call on Jan. 22.)

Pandit's Predicament

The changes now afoot contradict what CEO Vikram Pandit has been telling the market for months—that he wouldn't split up Citi. But as the economic and credit climate has deteriorated, the government—Citi's largest shareholder, with a 7% stake—is likely nudging Pandit to shift his strategy and raise more capital. And the 52-year-old executive has little choice but to follow orders.

Citi isn't the only bank in need of fresh cash. Federal Reserve Chairman Ben Bernanke said in a speech to the London School of Economics on Jan. 13 that the government will probably need to inject more capital into the banking system. Additionally, the Fed may need to backstop more toxic assets—as it did with Citi back in November—"to ensure stability and the normalization of credit markets."

All of Citi's recent posturing may be obfuscating the real issue: the bank's portfolio of toxic assets, which is becoming increasingly troublesome. While Citi gets a $6 billion aftertax gain from the joint venture, it does nothing to alleviate the problems in that portfolio. According to some estimates, the toxic assets on the books—consumer, corporate, and leveraged loans—could stand at $150 billion.

"The hole in the balance sheet is the problem," says a senior executive at a financial firm that specializes in fixed-income securities.

Citi's Government Backstop

So what will happen between now and the bank's earnings conference on Jan. 22? Some market observers suspect the government will directly buy up Citi's assets or provide a backstop for all the toxic securities on the books. In effect, such action will mirror the original intent of TARP, the Troubled Assets Relief Program, as first drafted last summer.

"TARP was designed first to restore the secondary market, which was far more important," says Robert B. Albertson, chief strategist at Sandler O'Neill + Partners, a boutique financial services investment bank in New York. "It is economic quicksand to give or lend banks the money now."

Others say the government needs to take more drastic action, taking Citi into receivership, wiping out equity and likely debt-holders in the process. Then, the government would need to carve out the bad assets into a separate entity, following the good bank-bad bank structures set up in the wake of the savings & loan crisis in the early 1990s. "Until you separate those toxic assets and put a bottom to the pricing and trading of those instruments," the market will be in no-man's-land, says Tom Barrack of money manager Colony Capital.

Barrack believes the government will act in this way because he has seen it happen before. After the S&L crisis, Barrack's firm bought American Savings, a failing thrift the federal government had seized and chopped into the bad bank-good bank structure. "I am a big fan of Hank Paulson, but TARP has been an abject failure," says Barrack. "I compare the situation to a fire on a Savannah Plain: Let it rip and burn, and the market will rejuvenate so much faster—try to control or impede it, and there will be more and longer suffering before renewal. Japan experienced two decades of economic paralysis by experimenting with fire control of a similar unproductive sort."

Der Hovanesian is Banking editor for BusinessWeek in New York.

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