Mike O'rourke March 2

It is fitting that this week Warren Buffett told his shareholders that he has done some “dumb things.” What is noteworthy about the admission is that he does not classify his most criticized moves, the purchase of preferred shares of Goldman Sachs* and General Electric, in that manner. In a similar spirit of accountability, we acknowledge that we have written some dumb things. We have continued to advocate that Treasury and the Federal Reserve finally know how to tackle the collapse of confidence in the Bank stocks. At the center of the Citi story, as well as that of the banking system as a whole, is the debate between Regulatory Tier 1 Capital and Tangible Common Equity (TCE). Under the belief that Tier 1 Capital and Basel meant something, we have advocated that the government and institutions should stand behind the regulatory framework in existence. Doing so will give the institutions and shareholders a fighting chance with only moderate dilution. We believed that Treasury finally understood that the key to survival is ending the vicious cycle of shareholder wealth destruction. The government’s actions in September of nationalizing/diluting shareholders at the bottom only pushed the market fear upwards in the credit structure, i.e. preferred shareholders breathed a little easier knowing that there was still equity below them to serve as a buffer and which would be wiped out first. Then, two days after Treasury and the Fed announced the Capital Assistance Program (CAP), which is intended to restore confidence in the banking system, and the day after the Fed Chairman, the Treasury Secretary and the Chair of the FDIC all rejected calls for nationalization, the regulators permitted Citigroup to undermine the process. The dilution of Citi’scommon shareholders is not a surprise, but to allow the Citi move to undermine the confidence in other institutions could be another awful mistake that will feed the vicious cycle. This appears to be a move initiated by Citi management according to media reports and if you consider Treasury’s statement that “Citigroup requested that the Treasury participate in this exchange offer by converting a portion of its preferred security to common equity alongside the other preferred holders.” The market deserves to know why Treasury did not simply make Citi wait until the stress testing is complete, along with every other major institution. Why Citi is voluntarily moving towards GSE and AIG status is also perplexing. Something is amiss about how and why this is unfolding here and now.

The TCE debate loomed around Citi for months, but the previous deals with the government have kept the bank “Well Capitalized” under regulatory guidelines. On Citi’sconference call on Friday, there was inconsistency between the statements made and actions taken. Vikram Panditstarted the call by remarking that “this morning, we have announced that we will be strengthening our TCE and our capital structure by offering to exchange common stock for preferred, and Gary will take you through the details in a minute. As you know, on the basis of Tier 1 as risk capital and based on our Tier 1 of 11.9%, we have been very well capitalized.” At the conclusion of the call, when asked whether Tier 1 or TCE was the more important measure, Panditresponded “Clearly, Tier 1 is, in our view, and continues

to be the risk capital that drives the business. None of that has changed at all. Having said that, what we are saying is that in reaction to all the focus on TCE, particularly through the challenging environments that we've gone through, we’re also of a point of view that Tier 1 and TCE need to have some ratio that represents a balance.” If it was clear that Tier 1 was the key measure, Citi would not be diluting its common shareholders by 58%-74% and extorting preferred shareholders into conversion by cutting off dividends. Yet despite these actions, the company reported that their “overall financial results in January were strong. Institutional clients were very active. Quarter to-date, adjusting for foreign exchange, our deposits weredown about 2%. That's consistent with seasonal patterns in how deposits typically perform this time of year. We continue to make excellent progress on the managerial split of Citicorp and Citi Holdings. That said, we're still a long ways, of course, from the end of the quarter, and market volatility could change results very quickly.” It sounds as if theoretically, the company is better off today than it was in Q4. Citi claims that its stress test is more stringent than the government’s. In the end, the company did not receive more capital,it was just transferred from column A to B. The franchise is further tarnished by what appears to be a third bailout (although they have not received money). Taking antishareholder actions while making such statements is ludicrous. Does management think that those market participants who have belabored the TCE argument are going to come in and invest in the company? Take it from us, they won’t. If anything, maybe they will close out short positions. Remember that the Chairman of the Federal Reserve essentially testified in front of Congress this week that the Fed could not take over Citigroup if it wanted to. If Citi’smanagement truly did initiate this process (which seems hard to believe), a Warren Buffett quote comes to mind. “Invest in a business that any idiot can run, because one of these days, an idiot is going to run it.”

Just as Citi is being inconsistent, so is Treasury. Treasury just unveiled the CAP to allay the fears of the TCE argument and allow banks to dilute shareholders over time, yet it ended the week by blessing a plan that totally undermines the purpose of the announced plan. For all the testimony we hear about negative feedback loops, the government is the number one perpetrator of them. Treasury’s response to Citi should have been, “you are ‘Well Capitalized’ from a regulatory perspective, we have laid out a framework as to how to proceed and you will follow that framework.” Sure dilution would come, but as expected during a process that has been laid out. Instead, some regulator is feeling better that Citi is diluting its shareholders before the process so they do not need to sign off on it later, while totally disregarding the damage done to the confidence in the rest of the system. The fear we should all have is that the government initiated this process. We know regulators have acknowledged and are aware of the TCE controversy, but if they give it regulatory credence, the result will be a pro-cyclical response to a systemic breakdown. It is important to know the truth here because either Regulatory Capital

matters or it does not. It is starting to appear as though Basel standards are not worth a roll of toilet paper. If this was a government induced action, then it is another sign that the rules are changing and TCE is what matters now and Tier 1 capital has been tossed out the window (and the first $350 Billion of TARP money was wasted). The government should recognize that it must be a stabilizing force. We have repeated numerous times that if you keep buckling to market expectations, the market will simply want more from you. Market expectations are synonymous with a negative feedback loop. If the government continues to chase market expectations, then, just like every other lemming, they will be led off a cliff. The problem is that they will take the rest of us with them.

There was once a young Treasury Secretary in a fledgling emerging market who recognized that the capital markets would be an important component of that nation’s economic development. At the time, those capital markets consisted primarily of government bonds and less than a handful of bank stocks. When panic would overtake the capital markets, Secretary Alexander Hamilton would step in and purchase the government bonds to stabilize the market rather than risk a setback to the young nation’s development. Secretary Geithnerand Chairman Bernanke do not necessarily need to “support” the market as Hamilton did over two centuries ago, but they need to provide that stabilizing force. They should not continue to feed the destabilizing forces. If Congress gets in their way, the Treasury Secretary and Fed Chairman need to fight them to the end. If the Fed pushed Merrill Lynch upon Bank of America, then the Central Bank should own that decision, admit they made it, and openly stand behind the merged institution. Treasury injected capital and provided insurances wraps last year to ensure banks are well capitalized under regulatory standards. If Treasury owns and commits to that decision, then the market ultimately will have to accept it. The policymakers have been hesitant to take ownership of the tough decisions in this crisis and that has led to further uncertainty. Ironically, despite the criticism heaped upon him, at the end of last year Secretary Paulson did say that no major institutions would fail. All of the sudden, the markets are pining for his return. The rejection of nationalization was the first step in this general direction. It took too long to occur but it was better late than never. If the TALF and PPIF are ever launched, they also will be bold steps in the right direction. The most stabilizing comments Chairman Bernanke has made are ones that have been extracted through Congressional testimony. They are statements that a Central Banker does not want to make, but the reality of the situation leaves no choice but to make them. Bernanke made one such statement last week, “To save the banking system you are going to need to save a few banks.” The market does not want an outline of the path forward one day followed by the approval of a contradictory plan a few days later. Policymakers need to embrace their decisions, stop chasing market expectations, put their necks on the line and stick to their convictions. Hamilton managed to do so in his day. We should expect

no less from his successors. Consistency will lead to stabilization. Without it, we will all wind up going off the cliff.

Mike O’Rourke, CMT Chief Market Strategist