Step aside, John Paulson -- there's competition for reaping billions from bets on the financial sector, and it comes from Uncle Sam. The government, which owns 34 percent of Citigroup (C) following a conversion of preferred stock from the TARP and asset guarantee agreement, has booked an $11 billion paper profit as shares have risen to $4.85 in trading today from the original $3.25 conversion price. The conversion was meant to bolster Citigroup's Tangible Common Equity, or TCE, a new measure being used to determine a bank's ability to absorb losses.
The rebound in Citigroup shares, which fell to under $1 at the height of market distress, is part of a rally in financial stocks as confidence in the sector has been restored. Citigroup has received $45 billion in TARP capital from the government, in addition to a loss-sharing deal reached on a pool of assets in excess of $300 billion.
As BloggingStocks notes, it's premature to say that giving capital to Citigroup -- or several other banks that have yet to return funds -- will turn out to be a good investment for taxpayers. Beyond the obvious conundrum of how to monetize such a large stake in a huge company without knocking the stock price down, it's also possible that the "gain" is only a consequence of a short-term boost from the government's increasingly implicit backing of major companies. In other words, the government has created a positive feedback loop whereby it subsidizes banks, and then investors bid up the price because it's "less risky" to own.
The reality is that the market can do anything short-term -- witness shares of AIG (AIG) tripling in the last month -- and a paper profit is only so useful in cases where the government is intricately involved in the survival of a firm. Ultimately, the fate of Citigroup's common stock will depend on embedded asset quality and the effective execution of the plan to downsize the company. That brings up some interesting disclosures in Citigroup's last 10-Q, which suggest that their assets have the highest market value of major banks, even though Citi has reserved the most for losses on those same assets. As the plan to break up Citi continues, only one thing is for certain: more volatility is ahead.
James Cullen edits and writes at CollegeAnalysts.com. He has no personal position in the stocks mentioned above.