Fresh Wave of Downgrades Slams Financial Sector

Another round of ratings cuts took its toll on the financial sector Thursday, and sent shares of Citigroup to their lowest level in nearly a decade.

Goldman Sachs analyst William Tanona cut his rating on U.S. brokerage sector to "neutral" from "attractive," saying there aren't any catalysts to move the group higher over the next few months.

Tanona also added Citigroup to Goldman's "Americas Conviction Sell" list. The analyst expects both Citi and Merrill Lynch to take another round of writedowns.

The move came as Goldman itself was downgraded to market perform by analysts at Wachovia, who cited a poor outlook for the brokerage business for their decision. The call may have surprised some as Goldman is often considered to be one of the strongest investment bank in the U.S.

In his research call, Tanona recommended a "paired" trade in which investors sell Citigroup shares short, betting on a decline, and buy Morgan Stanley shares.

Citigroup, the largest U.S. bank, may suffer $8.9 billion of second-quarter writedowns, forcing it perhaps to cut its dividend again, while Merrill may incur $4.2 billion of writedowns, Tanona said.

Capital, Dividend Concerns 

Citigroup's 32 cents-per-share quarterly dividend is "not safe," and that the bank may have to issue common stock or sell assets to raise capital because regulators may forbid it from issuing more preferred or convertible securities, he said. Tanona said halving the current dividend could preserve $3.5 billion of capital annually.

"We see multiple headwinds for Citigroup including additional write-downs, higher consumer provisions as a result of rapidly deteriorating consumer credit trends, and the potential for additional capital raises, dividend cuts, or asset sales," the analyst said.

In morning trading, Citi shares were down $1.03, or 5.5 percent, at $17.82 on the New York Stock Exchange. The shares were among the biggest drags on the Dow Jones industrial average and Standard & Poor's 500, which both fell more than 1 percent.

They also touched their lowest level since October 1998, the month that Sanford "Sandy" Weill merged his Travelers Group with Citicorp to create Citigroup.

Merrill shares fell $1.57, or 4.4 percent, to $33.85.

Trouble for Pandit?

Tanona's forecast suggests deeper problems for Citigroup Chief Executive Vikram Pandit, who is trying to turn the bank around after nearly $15 billion of losses in the last two quarters, and more than $46 billion of credit losses and write-downs since the middle of 2007. (For more analysis of the Goldman research call, see the video below.)

Pandit became chief executive in December, replacing Charles Prince, who resigned under pressure the previous month. Weill had hand-picked Prince as his replacement when he gave up the top job in 2003.

Last week, Citigroup Chief Financial Officer Gary Crittenden said on a Deutsche Bank conference call that the bank could take substantial write-downs this quarter.

Tanona said Citigroup might write off $7.1 billion related to collateralized debt obligations and associated hedges related to monoline insurers, $1.2 billion for other asset classes and $600 million for structured note liabilities.

He now expects Citigroup to lose 75 cents a share this quarter, compared with his earlier forecast of a profit of 25 cents. He also expects a full-year loss of $1.20 a share, compared with his prior view for a profit of 30 cents.

As of May, Citigroup had raised some $42 billion since last fall, including injections from sovereign wealth funds, data compiled by Reuters News show.

Tanona said the bank may now need to issue common stock or sell assets to raise capital, because regulators may forbid it from issuing more preferred or convertible securities. He also said halving the dividend could preserve $3.5 billion a year.

"Given the firm's current level of earnings power, we do not believe the dividend is safe," Tanona wrote.

A Citigroup spokeswoman declined to comment.

On June 24, Merrill Lynch analyst Guy Moszkowski projected $8 billion of write-downs for Citigroup.

Tanona also downgraded the U.S. brokerage sector to "neutral" from "attractive," saying deteriorating fundamentals will likely prolong any recovery from the credit crunch.

He projected a $4.2 billion second-quarter write-down for Merrill Lynch, leading to a quarterly loss for the largest U.S. brokerage.

"We expect write-downs for Citigroup and Merrill to outpace what we saw from Morgan Stanley and Lehman Brothers Holdings recently, due to Citigroup's and Merrill's large exposures to ABS CDOs (asset-backed security CDOs) and associated hedges with the monolines," Tanona wrote.

Brad Hintz, a Sanford C. Bernstein & Co analyst, on Thursday projected a $3.5 billion second-quarter write-down for Merrill. Banc of America Securities analyst Michael Hecht made the same forecast earlier this month.

On June 17, Goldman analysts led by Richard Ramsden said U.S. banks may need $65 billion more capital to cope with a global credit crisis that will not peak until 2009.

--CNBC.com contributed to this report.

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