Lost Citi Begins to Find Its Way Back Home

Citigroup shares are up more than 70% in the past four weeks. That isn't a typo. More to the point, the market isn't making a mistake.

For months, Citi lagged behind as shares in other troubled banks took off. The wariness made sense. Throughout the credit crunch, Citi's balance sheet has had a habit of springing nasty surprises. The added fear: As part of a preferred-for-common stock exchange, the government is taking a 34% voting stake in the bank, which investors feared could lead to disruptive interventions.

Ironically, it is the exchange that made Citi a buy. In short, it solved the bank's chief weakness, a dearth of tangible common equity. Banks lacking TCE are risky stock investments because shareholders stand to be diluted by the capital raises needed to boost equity.

At the end of June, the bank had just under $40 billion of TCE, hardly a sufficient buffer to support $1.8 trillion of tangible assets in a tough economy. After the exchange, the estimated proceeds from two deals, as well as the expected hit from bringing assets onto its balance sheet, Citi would have just over $100 billion of TCE. That would be equivalent to about 5.1% of tangible assets -- high for a big bank.

And the higher TCE ratio helps with Citi's other big weakness. The bank has to deal with a large amount of long-term debt coming due, $112 billion from 2010 through 2012.

It is unlikely Citi could have accessed debt markets in the size it did this year without issuing through a government-guaranteed program. That goes away in October. True, the government always can bring it back if needed. But if that were to happen just for Citi, the bank might strengthen its reputation as the sector's problem child.

That now looks less likely. The stronger TCE buffer affords creditors more protection. And if Citi's balance sheet shrinks as planned, it likely won't need to issue the full $112 billion to pay down maturities.

Skeptics note that Citi's TCE total reflects a $42 billion net deferred-tax asset. This balance-sheet item can have value because it can be used to lower income taxes. But the bank needs to make money to use it. And companies have to haircut this asset if profitability takes longer than expected to return.

While that is a risk, Citi has assets it could sell to generate a profit specifically aimed at retaining the value of the deferred-tax asset.

Meanwhile, political fears seem overdone. Despite sitting on a $10 billion paper profit, the government isn't likely to sell out soon, as the stake gives it useful leverage if Citi's management slips. And, so far, pressure from the government and regulators actually may have helped drive Citi forward in certain areas, particularly corporate governance.

Losses will, of course, weigh on Citi. The government's stress tests estimated worst-case losses of $105 billion this year and next, almost equal to the new TCE total. But Citi's loan-loss reserve, which absorbs losses before they hit TCE, is now $37 billion. At 5.6% of loans, it is substantially higher than for most rivals. Citi should also generate pre-provision earnings over the period.

Perhaps the rally hasn't priced all of this in. Citi trades at about one times its estimated new TCE per share versus about 1.55 times for Bank of America, adjusted for recent transactions. It mightn't get there if earnings or the economy disappoints. But if Citi performs, the problem child could continue winning over those who shunned it.