January 15 2008: 4:22 PM EST
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Citi's credit hangover

The pain for Citigroup (and its investors) is likely to continue as it deals with the aftereffects of its credit-lending and underwriting splurge.

By Roddy Boyd, writer

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Vikram Pandit took the CEO job in December.

NEW YORK (Fortune) -- Citigroup's $9.83 billion loss may be only the first of many painful adjustments the bank will need to make as its new management comes to grips with the credit collapse.

In Tuesday's conference call, new chief executive officer Vikram Pandit and his chief financial officer Gary Crittenden laid out a fearsome combination of bitter medicine and gloom. And Citi's $18.1 billion in write-downs might just be the end of the beginning of the reckoning process for the bank's five-year credit-lending and underwriting splurge.

By midday, Citigroup's (C, Fortune 500) stock price dropped $2.24 to $26.81, a decline of more than 7.8 percent.

Wall Street had been hoping for a one-time charge-off, but with the ongoing malaise in the arcane securitized markets Citi once dominated, coupled with billions of dollars of debt still on its balance sheet, the announcement looked more and more like the first of many.

The bank said it was taking a $14.3 billion write down for what CFO Crittenden said was $42.9 billion in exposure to so-called super-senior collateralized debt obligations. Overall, the bank has $37.3 billion remaining in a CDO book that last year was both envied by its peers and highly profitable.

Oppenheimer analyst Meredith Whitney, who argued in November that the bank was likely to face a severe capital shortfall, asked management if a ballpark valuation of 43 cents on the dollar for its $3.6 billion in remaining mezzanine tranche exposure - mezzanine tranches are the second-lowest rated pieces of a CDO - was accurate. CFO Crittenden "declined to confirm" the valuations the bank had assigned to the paper.

Citi's management also took all the moves expected from a company in crisis: Raising an additional $14.5 billion, cutting another 4200 jobs, announcing unspecified asset sales, and (here's the side order of gloom) slashing the once sacrosanct dividend 41 percent.

That dividend cut is the clearest indication yet that earnings are going to be sharply lower for the foreseeable future, although management couched this revelation in cryptic corporate-speak, saying Citi needed to return to a "More normalized level of earnings."

What the dividend cut really reveals is that with the CDO machine out of business, perhaps forever, the resulting blow to Citi's key derivatives units - much of the past two years' CDO output was constructed from derivatives - means the bank is unlikely to generate the earnings flow it once did. So "The normalized level of earnings," or earning $5 billion to $6 billion a quarter, may well be happy memories for the foreseeable future.

Citi management's past refusal to conserve capital and slice the dividend has proved costly in ways beyond the outlay of cash.

The 11.5 percent yield on the convertible preferred stock the bank sold to the Abu Dhabi Investment Authority in late November represented a 450 basis point spread to the yield on the common stock at the time. One hedge fund bank analyst estimated to Fortune that if the bank was using the common stock dividend as the benchmark for the convertible dividend, it could have saved in the ballpark of $300 million in the convertible dividend by chopping the common stock dividend sooner. (To be fair to the bank however, the deal may have been pegged off of an entirely different benchmark.)

The nature of Citi's past growth also bears examining as investors look at its prospects for the future. Citi's once-breathtaking profit growth was predicated upon an asset build-up that appears nearly unrivaled in financial history. Consider that at the end of 2005, Citi's assets were around $1.5 trillion, but by the end of the second quarter last year, the bank had expanded its asset base to $2.35 trillion, a change of $835 billion in 18 months.

However, Citi's equity in the same period grew to $127.1 billion from $112.5 billion. Thus the bank's balance sheet was leveraged over 50 times, with two cents of equity supporting more than $1 in assets. When asset prices declined sharply, an equity wipe-out became inevitable. To top of page