This revised and expanded version of our 12/28/06 analysis now includes a discussion of regulatory and business issues to be considered when assessing arguments that Citigroup should be broken up. -- The IRA

A number of analysts have opined recently that Citigroup (NYSE:C) is worth more broken up than as a going concern. Specifically, several analysts�argue that C should be selling business lines piecemeal�in order to enhance "shareholder value," short hand for boosting the near-term stock price.� Aside from being self serving, these arguments seem to�ignore some significant�business model�differences between C and banking industry�peers, at least those peers�based on market capitalization.

When you speak to inhabitants of the Buy Side, the�peer group selection for C usually includes names such as JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC) and Wachovia Bank (NYSE:WB). Trouble is, none of these institutions is a particularly good business model peer for C.� Thus the question: Do arguments about C's performance relative to market cap peers such as JPM or BAC hold water?� If you review the Basel II metrics for these institutions generated by the IRA Bank Monitor, using data from the FDIC, the disparity becomes clear.

HOLDING COMPANY	Total Assets (000)	Defaults	LGD	M	EAD	EC to Tier 1 RBC
BANK OF AMERICA	$1,353,389,310	56.6	75.10%	7.34	173.50%	1.703
JPMORGAN CHASE & CO.	$1,252,868,764	59.4	77.30%	3.1	210.80%	5.337
CITIGROUP INC.	$1,149,628,884	88.4	72.30%	1.63	246.80%	3.15
WACHOVIA CORP	$521,355,328	15.2	55.90%	5.84	77.90%	2.057
WELLS FARGO & CO	$427,593,917	35.2	72.70%	2.99	63.20%	0.64
HSBC HOLDINGS PLC	$168,902,842	80.3	74.90%	2.81	272.50%	3.44

Sources: IRA Bank Monitor/FDIC (9/30/06)

The first thing to notice in the table above is the low Weighted Average Maturity or "M" for C compared with JPM and BAC.� With a M of < 2 years for all of the group's�banking units, C has a maturity profile closer to a credit card specialization bank than a commercial bank.� Indeed, only institutions such as�Wells Fargo (NYSE:WFC) and HSBC Holdings (NYSE:HBC) evidence M that is even close to the short duration profile of C.�

Notice too the relatively high Exposure at Default or "EAD" for C, JPM and HBC, an illustration of the large percentage of unused credit lines in each institution.� In the case of C and HBC, this is mostly a function of a large consumer lending book, while for JPM it is a combination of retail and wholesale exposure.� Indeed, note the fact�that the ratio of Economic Capital to Tier 1 Risk Based Capital generated by the IRA Bank Monitor's Basel II simulation�is 5.337:1 for JPM vs. just 3.15 for C and 1.7 for BAC, a reflection of the former's massive trading book exposure.

While you can argue that JPM is a good peer for C on the institutional side of the business, it is pretty clear from the table above that neither BAC nor WB belongs in the same peer group as C or HBC.� Notice the huge duration risk on the balance sheet�of BAC, more than seven years, a profile it shares with WB, albeit�to a lesser degree.� Yet both BAC and WB are relatively conservative institutions in terms of the�low EAD and, in the case of WB, the excellent Loss Given Default rate of just 55%.�

Look too at the default rate for C -- 88.4bp for the first nine months of 2006 -- a rate only approached by HBC in this group of banks.�� The relatively high default rates and the likewise high gross loan spread or yield�are key business model indicators that can help more discerning analysts distinguish between different bank business models.� Question for break-up proponents: If WB has fewer�defaults in a year than C has in a single quarter, can these two banks be good business model�peers?

HOLDING COMPANY	ROA	ROE	Lending Spread (bp)	P/E
BANK OF AMERICA	1.57%	13.61%	704	12.4
JPMORGAN CHASE & CO.	0.86%	9.31%	717	13.9
CITIGROUP INC.	1.43%	15.70%	737	12.4
WACHOVIA CORP	1.23%	11.92%	653	12.7
WELLS FARGO & CO	1.65%	17.11%	768	14.9
HSBC HOLDINGS PLC	0.99%	12.22%	609	11.9

Sources: IRA Bank Monitor/FDIC (9/30/06)

Of course, many of the critics of C who want to see the bank broken up measure�valuation�in terms of short-term stock�price appreciation, not financial performance.� These are, generally speaking, the same folks who support the use of market cap weighted indices to determine portfolio allocations and benchmark the broad market,�both bad ideas in our book.� But if�you compare the "bank only" financial performance of C to the�market cap peers like JPM or BAC, the former's performance�actually is pretty good.� Note too that C's�P/E ratio is in the same neighborhood as the market cap peers, but below banking industry leaders�such as WFC and US�Bancorp (NYSE:USB).��

Looking at the financial performance of C, you have to really wonder why the critics are so unhappy.� Perhaps the stock performance of C has lagged the market cap peers like BAC and especially JPM, which is up around 20% LTM, but it seems hard to make the argument that C deserves a higher P/E multiple than these market cap peers.� One of the legacies of the�Sandy Weill (and Warren Buffet) era�was to move C toward a focus on sub-prime�and unsecured consumer lending, and away from areas like commercial real estate and derivatives.� Was it just a coincidence that C, after helping to invent the OTC derivatives market in the late 1980s, let JPM race ahead in terms of market share?�

C does have�the largest C&I; loan portfolio of any US bank, but at $147 billion as of June�30, 2006, that's just 10% of total banking�assets.� To us, the real story of C is told by the short portfolio duration and the high loan yields of some of the group's consumer banking units.� When you see loan yields in the 1,800-2,000bp range and default rates above 300bp annually, that is sub-prime territory.� While the numbers may look more benign on the consolidated, bank-only roll up�basis shown above, to us C is a�high risk franchise that is probably pretty well-valued at current levels.� That is, the market is right again.

If you want to be critical of C, in our�view, the place to start is the management suite, not the balance sheet.� CEO Chuck Prince is a skillful lawyer who was given the top job during a crisis in order to get C out of the penalty box with US regulators, this�after the Enron fiasco and other operational risk mishaps.� Now that C hopefully has put these issues behind it, the board of directors and Prince himself should be thinking about a replacement to lead the organization forward.� There is no criticism for Prince in this observation; he did the job and cleaned up the legal and regulatory mess left by Mr. Weill et al.� But Prince's�weak�performances in face-to-face meetings with investors�make it clear, to us at least,�that he is not the man to sell C's story to the Buy Side.�

Bottom line: Arguments that C should be broken-up seem wide of the mark, but the organization should definitely be in the market for a road-show ready CEO.

Part II -- Breaking Up Citigroup:� Regulatory and Business Issues
January 2, 2007

In addition to the valuation issues we discussed in our December 28, 2006 comment, we want to raise two other factors that, to us at least, mitigate against breaking up C into three pieces -- domestic bank, international bank�and investment bank.� We are thankful for the comments we received on our earlier analysis and make reference to same below.

Business Issues

When approaching the issue of breaking up the C organization into three, stand alone businesses, the first thing to consider is whether these former business segments could, in fact, stand on their own.� It was suggested by one commenter that the domestic business of C would be peered against BAC, the international unit against HBC and the investment bank against Lehman Brothers (NYSE:LEH) and Goldman Sachs (NYSE:GS).�

We question whether the value enhancement arguments that, superficially at least, might be persuasive in suggesting that these three separate business lines would be more valuable alone than in combination take into account the degree to which the international and investment banking units depend upon the infrastructure and credit standing�of Citibank NA.

For example, these proposed divisions do not follow the way in which�C currently manages its five�business silos -- global consumer, corporate and investment bank, global�wealth management, investments and technology.� �Nor does the domestic bank, international bank and investment bank thesis, a perspective�which seemingly arises from C's SEC disclosure, take notice of the legal entities upon which these activities depend.� (This is just one reason why we like to look at the regulatory, legal entity financial disclosure that we use in our Basel II by the Numbers � survey.)

Assume, for the sake of argument, that a break up were attempted that divided C into two consumer banks and the investment banking/wealth management�operations.� Would the proponents of the breakup of C�really argue that the domestic money center give up all of its foreign branches?� Likewise, would these same analysts really expect the international�bank to be viable without the support of the domestic management, credit,�clearing and back office infrastructure of Citibank NA�and its affiliates?� �

In our view, the only way to make the international bank viable as a stand alone business�would be to replace that infrastructure currently provided by Citibank NA with alternative personnel,�facilities and services, an expensive proposition that might partly or even entirely eviscerate the economic and�valuation benefit of the separation.� An outright sale of the international assets�to another organization would probably be more attractive, assuming that you accept the break-up, sum-of-the-parts,�argument in the first instance.� Indeed, we suspect that monetizing the foreign assets�is the true agenda of the proponents of breaking up C.

Likewise, we are dubious of the value creation leverage for the domestic bank of giving up its foreign branches.� Not only has Citibank NA done business in foreign venues for more than a century, but the US bank unit gains considerable earnings and growth potential from its offshore activities.� Once you deprive the US bank of these historical connections in high growth foreign markets, what's left is large�in terms of size,�risk profile and capital needs, but�not very exciting as a business or compelling as an investment opportunity.�

In fact, if you accept the three-part scenario for breaking up C, the domestic bank may be�the least attractive piece.� Analysts often cite C regulatory and operational risk problems as a reason for the dearth of significant�US acquisitions over the last several years, but we've heard many Citibankers privately thanking the Fed for taking�pressure off to do expensive, dilutive M&A; deals in the US.� To us, the biggest bang for the buck in terms of C shareholder value�comes from deploying capital outside the US.� Let BAC and WB pay 3x book purchasing large domestic�competitors at the top of the�market for�US banking assets.� Meanwhile, C is expanding in China.

Finally, we have to question�how any�reasonable analyst could believe that C's investment banking arm could survive on its own.� Much of the business flow that moves through the investment bank comes as a result of the affiliation with Citibank NA.���The investment bank's brokerage and advisory businesses in fixed income, foreign exchange and OTC derivatives, for example, all depend upon the relationship with Citibank NA.�

Sure, there are successful independent IBs�such as�LEH, GS and Bear Stearns (NYSE:BSC), but none of these -- even mighty GS -- can play in Citibank's league in OTC derivatives.� The bank's balance sheet is what makes the derivatives and corporate lending business possible and these segments�could not be separated from it.� When counterparties�transact an OTC�derivative trade with C the documentation specifies Citibank NA, not the holding company, and for�good reason,�as discussed below.

Regulatory Issues

The second issue, but one related to the business issues outline above, is the question of gaining regulatory approval for a breakup strategy.� Several commenters speculate to us that the tax and structural implications of a C breakup strategy, while daunting,�could be addressed by a swarm of�properly�incentivized�investments bankers and tax lawyers.� Perhaps.� But such arguments assume that regulatory approval could be obtained to break�the C organization into three completely independent pieces on terms that investors would accept.

Perhaps the most basic issued arguing against a breakup strategy is the question of how to carve up the assets of C into the three segments illustrated above.� From the outset, analysts supporting the break up thesis�must take notice of the fact that while economic efficiency arguments may be useful in persuading investors of the efficacy of their plan, regulators look upon such transactions based upon entirely different criteria, namely the statutory test regarding safety and soundness.�

When regulators look at transactions proposed by a bank holding company like C, arguments regarding capital efficiency and investment returns are not relevant.� As we have�noted, the Basel II Economic Capital simulation in the IRA Bank Monitor, using portfolio level data from the FDIC,�already suggests that, in a stressed scenario, C has too little capital to cover its existing�credit, market and operational risks.� Thus from the outset, the proponents of a break up strategy�would face an uphill battle convincing the Federal Reserve Board and other�regulators to let them divide C into three equally attractive pieces.

There are many issues involved in such a regulatory analysis, but we suggest that the 10,000 pound gorilla standing in that room is in which new business unit�the C OTC derivatives book would�reside.� As�a practical business or regulatory�matter, you cannot�separate the derivatives book from Citibank NA.� Likewise, we suggest that regulators would object should the proponents of the break up strategy try to cherry pick attractive foreign and domestic�assets from�Citibank NA and other US bank affiliates, leaving less attractive domestic assets and the highly variable derivatives book.�

We won't even comment on the idea of separating the non-derivatives investment bank into a�separate business unit because, in our view, the investment bank by itself, sans derivatives and the lead�bank's lending operations,�would not be�viable.� Just ask any manager of a major broker dealer if they believe that the cash side of the business trading in�stocks and fixed income instruments, and the investment management business,�could survive�without the double-digit margins generated by derivatives trading and advisory activities.

Bottom line:� We don't think that the domestic bank, international bank and investment bank thesis makes sense from a business perspective, nor do we believe that C could obtain regulatory approval to carry out such a plan in a way that would be attractive to investors.� And remember that as of 12/31/06, C was scheduled to�have consolidated the 17 banking units�which�existed a year ago down to just four, making a break up strategy even more problematic.� Next!

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