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Breaking up Citigroup: Some thoughts on a thoughtful rebuttal

Sean Ryan is a bank analystfor SaLaurMor Capital. The views and opinions expressed in this piece are thoseof the author and do not necessarily represent the views of S&P GlobalMarket Intelligence.

The mostthoughtful rebuttal I have seen of KBW's report on the merit of breaking upCitigroup Inc. camefrom Karen Shaw Petrou of Federal Financial Analytics, which isn't terriblysurprising since Ms. Petrou has long been among the most astute analysts of thebanking industry.

A briefitem in The Wall Street Journalreally failed to do her arguments justice, and her commentary deserves to beread in its entirety here.

Sheessentially argues that while sum-of-the-parts analyses may look good on paper,the devil is in the details, citing three potentially high hurdles toexecution: the open question of whether the hived-off business would in factenjoy less oppressive regulatory treatment, a paucity of ready buyers, and thepotential for lower credit ratings for smaller entities to offset any gains invaluation.

Theseare all serious concerns, but in the end, I suspect that the logic of a breakupstill carries the day.

Thequestion of regulatory treatment is fundamentally unanswerable. In a nationfounded on the rule of law rather than the rule of men, banks are now subjectto the fleeting whims of regulators to a degree more commonly associated withthird-world despotisms. It is entirely possible that entities broken off fromCiti would enjoy no reduction in regulatory burdens, and in fact would onlycede economies of scale in bearing them.

Allelse equal, that risk could be difficult to justify taking. All else is rarelyequal however.

Evenif, on day one, the Baby Citis enjoyed no regulatory benefit, and indeed wereforced to duplicate compliance efforts (and costs), the smaller firms would bebetter positioned to make their case for relief in an environment thatcontinues to evolve. It seems to me that the probability of Citi as currentlyconstituted is materially less likely to successfully argue for any regulatoryrelief than its potential successors would be, huge though they would still bein absolute terms.

Thefact that many ostensibly natural buyers currently have larger fish to fry isanother significant concern, about which I'd make a couple points.

First,depending upon the size of the particular business being sold, there could verywell be a role for private equity firms, which are sitting on enormous levelsof dry powder. Here again we encounter the problem of regulatory caprice, asnobody can say for certain whether our regulators' pathological hatred ofprivate equity investors exceeds their merely ill-informed hatred of hugebanks. It is quite possible, though, that our mandarins would choose privateequity, though your reading of the chicken entrails may differ from mine.

Second,if buyers are thin on the ground, then the clearing price of any transactionmay be lower than Citi shareholders might hope for, but price discovery isuseful even when we find the results uncongenial. Some recognition of thisstate of affairs seems implicit in Citigroup's price/book multiple, to whicheven sale prices materially below KBW's estimates would provide handsome upside.

Finallythere is the risk of potential ratings downgrades, and as precedent Ms. Petrounotes the experience of UnitedGuaranty, AIG'smortgage insurance operation. To the extent that downgrades came to pass, thereis no denying that they would cut into shareholder value.

Theonly countervailing factor I can cite is somewhat indirect and speculative, butcritical just the same. It is all well and good to seek regulatory relief butin the long run, the biggest benefit from breaking up a firm like Citigroup islikely to come from the energy unleashed by creating smaller, more focused,nimble and entrepreneurial companies. The converse is why conglomeratediscounts predate Dodd-Frank by, to a first approximation, all recordedhistory. Over time, I suspect that the effects from those factors dwarf theimpact from a notch or two in credit rating.

Ms.Petrou has raised important issues surrounding a potential breakup ofCitigroup, but in the final analysis, it seems to me that it is probably worthdoing anyway.