The Federal Reserve, the US Treasury Dept. and the Federal Deposit Insurance Corp. have agreed to help bail out $306 bn in risky loans and securities backed by residential and commercial real estate assets at Citigroup, in an unprecedented intervention to rescue what was once the country's largest bank.

Insiders say the bank may have no choice but to break itself up in a dramatic restructuring.

As reported to you Friday, the government now plans to take on the risk of Citi's bad paper in order to rescue the bank--potentially to the tune of $249.3 bn, with the government giving another $20 bn capital injection into the bank on top of the $25 bn it's already received from the government in a capital infusion.

The sums involved go beyond the government's $29 bn rescue of Bear Stearns, which went through an emergency merger with JPMorgan Chase in March, as well as for now the government's $150 bn bailout of the insurer AIG, and the $200 bn bailout of mortgage finance giants Fannie Mae and Freddie Mac. However, the rescue of AIG, Fannie and Freddie could grow.

Under the terms of the agreement, Citi absorbs the first $29 bn in losses on the pool, plus 10% on ensuing losses for a total of $56.7 bn in potential losses to the bank.

As reported to you Friday, the resulting plan now involves the government, including the Federal Reserve, taking on the risk of Citi's bad paper. Some $249.3 bn, for now, is involved, representing less than a tenth of Citi's on-balance and off-balance sheet assets. The asset rescue for now does not include Citi's credit card portfolio.

The Treasury could take the hit on $5 bn in losses on these assets, the FDIC the next $10 bn with the Federal Reserve potentially backstopping the remaining $234.3 bn in potential losses via a non-recourse loan to Citi (the government does have recourse to Citi assets for the interest portion of the loan).

Besides Bear's $29 bn in bad credit derivatives (now valued at $27 bn), the Fed is also overseeing $52.5 bn in bad paper from AIG in the government's rescue of the damaged insurer. Both AIG and Bear's assets are held in off-balance sheet funds at the Federal Reserve. The government has funded these vehicles to take on these assets.

The government will also invest an estimated total of $27 bn in new capital in Citi, on top of the $25 bn in preferred equities it has already bought earlier this year. The Treasury invests about $4 bn, the FDIC, $3 bn, an investment Citi granted in payment for the government's massive backstop on its assets. At its $3.77 closing price on Friday, Citi's $20.5 bn market value was below the government's initial $25 bn purchase of Citi's preferred shares.

Citigroup gets to keep the income stream from the guaranteed assets. The government's guarantee is in place for 10 years for residential assets, five years for commercial real estate.

In return, the government will get an 8% dividend on the entire slug of new shares, more than the 5% dividend other banks must pay if they get a TARP injection. The government also receives warrants to buy more Citi shares, some $2.7 bn worth of Citi's common, or about 24 mn shares at an estimated $10.61 each. 

In exchange, Citi will have to slash its dividend payout to 1 cent per share per quarter over the next three years, down from 16 cents. Citi's stock price has dropped 89% in the last 52 weeks, and Friday closed at $3.77. To date, Citi has raised $75 bn in capital.

Also, the new plan keeps in place the present management of Citi, including chief executive Vikram Pandit. The government now gets to approve Citigroup's long term compensation and bonuses for executives.

Citi now has to work to modify the loans underlying the assets in the pool, the Treasury, Fed and the FDIC said in a joint statement. Doing so may help bolster the value of the distressed securities.

"With these transactions, the US government is taking the actions necessary to strengthen the financial system and protect US taxpayers and the US economy," the Treasury, Fed and FDIC said in a joint statement.

And the US government dismissed the notion that it will not come to the aid of other distressed banks with potentially similar moves.

"We will continue to use all of our resources to preserve the strength of our banking institutions and promote the process of repair and recovery and to manage risks," the three said in the joint statement, adding it "will carefully circumscribe the involvement of the government" as it supports bank efforts "to attract private capital."

Talk inside the bank is that management must move more rapidly to downsize it dramatically--painfully hard to do in a frozen solid credit market. Insiders still say a merger with a deposit-taking bank is not off the table. Citi failed in its attempt to buy Wachovia Bank earlier this year, in an effort to pick up that bank's deposits in order to help plug its balance sheet holes. 

Citigroup, with $2 tn in assets, $2 tn in liabilities, and $1.2 tn in off balance sheet assets, is too big to fail, government and bank officials say.

Already, Citi has moved about $80 bn bad assets off its trading portfolio and into its long-term investment portfolio, so it doesn't have to mark those assets to market each quarter and take ensuing writedowns. 

Citigroup has an outsized balance sheet that is making it difficult to find a merger partner who can digest it. Its $2 tn in assets and $2 tn in liabilities is backstopped by $131 bn in net worth. That net worth is swamped by more than $130 bn in bad assets right now, though Citi adamantly says it has adequate liquidity to see it through the credit crisis and its fundamentals are sound. Another $1.2 tn sits off-balance sheet.

Citi has recorded $24.7 bn in losses in the last four quarters, with analysts expecting $3.5 bn more in the fourth quarter and tens of billions more down the road. Citi's decision to move $80 bn in severely damaged assets off its trading portfolio and into its long-term investment portfolio or what is called "available for sale" is a Hail Mary pass to try to forestall future writedowns, as it now won't have to mark these assets to market each quarter.

A Citigroup spokesman declined comment.

The government's decision to kill its initial plan to buy troubled asset-backed securities has hurt Citi, insiders say. Insiders were disturbed by the government's plan to not let the Troubled Asset Relief Program buy up toxic assets, which could have taken pressure off of Citi's beleaguered balance sheet.

Citi's balance sheet took on more water when top executives recently opted to bring back onto the bank's financials $17.4 bn in debt securitizations held off-balance sheet in structured investment vehicles.

Citi's market capitalization is now less than Home Depot, Comcast, Walt Disney, USBancorp, Pepsico, McDonald's, Intel, Amgen, Merck, Qualcomm, UPS, Anheuseur Busch, 3M, Kraft, and Colgate Palmolive.

Unloading divisions to streamline Citi for a merger would be painful. Being talked about now is having Citi hang on to its consumer retail branches, as well as its wealth management business, which houses Smith Barney and corporate banking, and cash management and transaction processing. Its trading desks and investment banking unit could get dumped, notably the former where many of Citi's problems with a ballooning subprime securities portfolio began. 

Chief executive Vikram Pandit is adamantly against a breakup and is sticking fast to its "universal" bank model, insiders say, and believes Citi can remain independent, arguing the bank has adequate liquidity. The bank has at least $50 bn of capital in excess of the amount required by regulators to qualify as ``well capitalized," insiders say.

Deutschebank's Michael Mayo, a top bank analyst on Wall Street, estimates that Citi has a $100 bn cushion against losses, based on tangible equity of $48 bn, the government's $25 bn purchase of preferred shares, and $25 bn in reserves, "which should be enough to cover estimated cumulative lossses of $50 bn" in future quarters.

Mayo adds that Citi may have anywhere from $7 bn to $20 bn in future writedowns on damaged securities and loans, though it's unclear what sum may be recorded because, as noted, Citi did move $80 bn "away from mark-to-market accounting." Mayo estimates a $9 price target on the stock, based on an estimated 0.9 times estimated third quarter tangible book value.

To date, bank deposits have held steady, and corporate and brokerage customers so far are not pulling accounts.

However, events are fast overtaking the bank.

Merger Partners?

A government-backed merger with another bank, overseen by the Federal Reserve and the US Treasury Dept., is still a possibility. A merger with a more stable regional bank including US Bancorp  or Wells Fargo has been discussed.

JPMorgan Chase's name was brought up as well, though JP is still digesting its acquisitions of Bear Stearns and Washington Mutual.

Goldman Sachs and Morgan Stanley were also discussed as merger partners, as the two are now bank holding companies with access to deposits. A deal with Chevy Chase is moving to the back burner, as Citigroup had considered buying the bank with stock instead of cash, a non-starter given the steep plunge in its share price. Also, Capital One Financial, BB&T Corp., JPMorgan Chase and SunTrust Bank are said to be vying for Chevy as well.   

One idea, to get the Securities & Exchange Commission to reinstate the short-selling ban, would have little effect as analysts argue that some level of the bank's short interest might be keeping a floor under the damaged stock.

The White Hot Zone on Citi's Balance Sheet

What is causing the meltdown in the form of record writedowns at Citi? The numbers are as follows: $18.1 bn in asset-backed collateralized debt obligations, including CDO-squared, and another $22.5 bn in other CDOs as well as subprime loans purchased for sale or securitization. A total of $80 bn in damaged assets.

Wall Street has pounded the stock down to record lows due to fears that Citi has insufficient capital to absorb mounting loan losses and writedowns to asset-backed securities, despite its protestations of having sufficient capital.

Buried in Citi's third quarter results, you'll see these numbers: $133.4 bn in assets it can't get a price tag on because the markets are frozen solid for these items. And another $54.4 bn in Kryptonite liabilities, subject to the same iceberg of a credit market. Citi does say it hedges these items.

Citi also has a $16.9 bn commercial real estate trading book and a credit card division getting pummeled by the credit crisis and a terrified consumer.

Also, nine of Citi's investment funds have cratered this year.

Also in a footnote in its third quarter report: Citi has a notional derivatives exposure amounting to $36.8 tn, including equity, commodity and foreign exchange swaps. Trillion--though it of course hedges those positions.

Employee Anger

What insiders are saying:

"This credit crisis is more than a year old. Why didn't our top guys consider a merger with a bank that can take deposits months ago?"

"Why not do layoffs and do much more asset sales sooner?"

"Why didn't the leaders announce they would forgo bonuses when they announced this week 52,000 more layoffs (on top of the layoffs already announced, bringing the headcount down by 75,000 to below 300,000)?"

Note: Pandit and three deputies did recently buy a total of 1.3 mn shares in Citigroup. Those shares are now under water.

Plunging Consumer Business

Besides wealth management, Citi's consumer business, its consumer loan and credit card business, has historically stood squarely behind Citi's profits.

However, the bank's last quarter saw net revenues of $16.7 bn, down 23% from a year ago.

As consumer confidence has plummeted, sales in Citi's global cards business dropped a precipitous 40% in the last quarter. Delinquencies have risen.

It's estimated that the slug of Citi's $202 bn in residential mortgages more than three months late doubled to 3.85% versus a year ago. Estimates have it that delinquencies in its auto loan book, amounting to some $19.7 bn, rose to 1.78% from 1.26% a year ago. Overall, the percentage of its consumer loans now delinquent rose to 3.35% in the third quarter versus 1.87% in the same period a year ago.

The fourth quarter is expected to look worse, as consumer spending has dropped dramatically in October, the steepest drop since 1992 after Gulf War I.

Costs for bad loans have almost doubled in the past year to $9.07 bn in the third quarter, with net credit losses in the banks' consumer divisions amounting to as much as $8 bn for all of 2009.

Instead of the Citi that never sleeps, it's now being called Citi, where the writedowns never sleep, so goes the black humor on Wall Street when it comes to its profit results.