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Citigroup's LBO Dance Card Proves too Full

Citigroup has admitted to pulling up lame doing the leveraged buyout dance. Now it must prove the injury was more superficial than disabling.

Citigroup Chief Executive Charles Prince famously told the Financial Times in July that with the leveraged buyout frenzy, "as long as the music is playing, you've got to get up and dance. We're still dancing."

That spirit has come at a steep price, the bank revealed Monday, though some analysts said it may not be steep enough.

Citigroup estimated a 60% drop in third-quarter earnings, citing losses on its leveraged lending portfolio as a leading cause. The biggest U.S. bank by market value took a $1.4 billion pretax writedown on a total of $57 billion in leveraged loans as of the end of the quarter.

Banking analysts wondered if the bank had fully captured its troubles with these high-risk, high-reward loans made to unrated and junk-rated companies.

"Can Citi really know what the size of the write-offs should be?" said Punk Ziegel analyst Dick Bove. "All they know is they got a bunch of loans which they put on their books which were inappropriately underwritten in the first place."

Citigroup underwrote loans for such leveraged buyouts as First Data, bought last month by Kohlberg, Kravis, Roberts for $26 billion. Nearly $10 billion of term loans behind that deal were sold to investors last week for 96 and 97 cents on the dollar, according to Reuters Loan Pricing.

Based on how that debt was discounted, a more reasonable writedown for the leveraged loan portfolio would have been about 5%, said Sean Egan of independent ratings company Egan-Jones, which would be twice what Citigroup did. He called the $1.4 billion writedown "light" given the portfolio size.

Yet Egan added that if the Federal Reserve cut rates again, Citigroup would have an easier time exiting its loan exposure.

"There is a fair amount of uncertainty because of shifts in the rate environment," he said.

More to Come?

On a recorded call, Prince said the bank took writedowns on all highly leveraged loan commitments where there were losses, but acknowledged the bank continued to sort through the loans.

"We continue to actively renegotiate and restructure the transactions to ensure they are executed at optimal terms," he said.

Activity on leveraged finance desks soared in recent years as frothy debt markets fueled by low interest rates sparked an unprecedented private equity buyout boom.

Private equity firms, which snap up companies with mostly borrowed money, have done $700 billion of deals this year, or double the level last year, according to data provider Dealogic.

Given the need to finance all these deals, U.S. leveraged lending has boomed, with loan origination of nearly $450 billion this year versus about $140 billion in all of 2002, according to Standard & Poor's Leveraged Commentary and Data.

Investors pulled back from leveraged debt after a subprime mortgage meltdown prompted a credit crunch this summer, and initial damage reports are already in from some banks.

Bear Stearns said last month it was writing down its $7.6 billion portfolio by $250 million, or 3.2%. Morgan Stanley wrote down its $31 billion portfolio by $726 million, or 2.3%.

Of the five top leveraged loan bookrunners -- JPMorgan Chase , Bank of America , Citigroup, Deutsche Bank and Credit Suisse -- only Citi has quantified writedowns related to leverage loans as part of a pre-earnings announcement.

However much they write down, there's no doubt that leveraged loans, which once made healthy contributions to banks' bottom lines, are now a drag on them. Banks will have to
offer favorable terms to investors in order to unload them.

"People will take the leveraged loans," Sanford Bernstein analyst Brad Hintz said. "It's just that if Citi committed at 5%, the market may ask for 6. So Citi will lose money on the deal."

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