Does Citi have a capital crisis?

NEW YORK (Fortune) -- It's one of the hottest debates in the market right now: Is Citigroup short of capital?

Citigroup (Charts, Fortune 500), wounded by huge losses on mortgage-related assets and currently without a permanent CEO after Chuck Prince resigned Sunday, might lack the capital to weather a credit storm that shows few signs of abating.

Bank analysts wonder whether Citigroup has sufficient capital to weather the turbulent Wall Street storms.

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The bank said Sunday that losses from mortgage-backed assets could be as high as $11 billion in the fourth quarter.

Meredith Whitney, a bank analyst at CIBC, intensified the debate about Citi's capital on Monday when she declared that the company's math used to justify paying its dividend "just doesn't add up."

Asked for comment, a Citigroup spokeswoman referred to recent statements in which the bank and senior executives say Citigroup has sufficient capital for now and won't cut its dividend to increase capital levels.

The scrap over Citi's capital level is a lot more than an arcane debate over a number. If Citigroup lacks sufficient capital, it means that one of the world's largest banks is vulnerable to worsening conditions in the credit markets, suggesting that other banks, too, may hit trouble.

How can this be measured? Capital is broadly defined as what's left for shareholders after subtracting a company's liabilities from its assets. For banks, capital measurements are critical, because they show how much borrowing a bank is doing, and because capital numbers indicate how much "cushion" exists to absorb losses. Bank regulators closely track capital at banks, while rating agencies carefully weigh capital levels when coming up with a rating for banks.

Citigroup in particular needs to be concerned about capital. The bank's capital levels have fallen considerably since the start of last year, leaving it with capital ratios well below those of most of its peers.

Of course, there are many ways to measure capital, but let's focus on two key ones. A capital ratio that regulators look at is called the "Tier 1 ratio," which takes into account the type of assets a bank holds. Currently, Citigroup's Tier 1 capital is at 7.3% of assets as of Sept. 30, according to the bank, which is down from 8.6% at the start of 2006.

Further, Citigroup looks especially weak on a measure called "tangible capital to tangible equity", a measure that strips out certain "intangible" assets - such as goodwill - that are tricky to value. That yardstick was at 2.8% on Sept. 30, down from 4.3% at the start of 2006, and well below JPMorgan Chase's (Charts, Fortune 500) 4.2% tangible capital ratio, as of Sept. 30.

Looking at the tangible measure in particular, Whitney believes that Citigroup needs to raise $30 billion of capital, and may have to do things like sell assets, issue new stock or cut its dividend, which pays out $2.7 billion of cash each quarter.

A cut in the dividend would be a big step. The last time Citigroup (actually, one of its predecessor companies, Citibank) did that was 1990, when it was deeply in trouble. But once the negative headlines faded, cutting the dividend - and taking other capital-boosting measures - could be a smart move, as it would strengthen the bank during a difficult period.

Are such dramatic measures likely? Citigroup's management doesn't think there is any pressing need to take big steps like cutting the dividend to raise capital.

For example, on Monday, Citigroup's chief financial officer, Gary Crittenden, said that the "normal ongoing profitability of the company" will help build up capital ratios (because earnings boost capital). Unfortunately for him, there's nothing normal or particularly profitable about Citigroup at the moment. Indeed, some analysts expect an overall net loss at the bank in the fourth quarter, because of the mortgage-related writedowns, and then the consensus seems to be that Citigroup will report low profits in the first part of 2008.

Typically, if a bank sees economic troubles and a tight credit market ahead, it will go out of its way to trumpet its balance sheet strength. Management may, for example, underline its commitment to protect the company's credit rating by announcing capital preservation moves - such as cutting the dividend - to satisfy rating agencies. Such a response would seem to make sense for Citigroup, given its huge expected mortgage losses, the likelihood of more bad loans in its consumer lending business, uncertainty about the bank's risk management and the possibility that it might have to step in and use even more of its own balance sheet to clean up problems at the large bond funds it manages called structured investment vehicles (SIVs). Citigroup recently loaned its SIVs $7.6 billion.

And partly because of these difficulties, Fitch on Monday downgraded Citigroup to AA from AA-plus, while Standard & Poor's said its AA rating was on a negative watch.

If Citigroup ends up failing to produce enough profits to bolster capital, management will appear to have been too slow to act. Investors could then lose confidence in management - and if there needs to be a capital increase at that point, it might take a heavy toll. And investors are already wary; Citigroup stock is trading at a 52-week low and is down 34% for the year.

"We would have rather seen the company take action now to conserve its financial resources, since there seems to be no indication yet that anyone knows when the credit crunch will bottom out," says Kathy Shanley, a credit analyst at Gimme Credit.

Granted, plenty of analysts think Citigroup has enough capital, pointing to the fact that the Tier 1 ratio of 7.3% is well above the 6% floor that regulators classify as "well capitalized." But the Tier 1 ratio relies on something called the "risk-weighting of assets." That means a bank gets to go through its balance sheet and apply different levels of capital to different assets, depending on their perceived creditworthiness. Trusting Citigroup management's subjective valuations might not be so wise. Citigroup, for example, before Sunday gave no indication that its expected losses on mortgage-related assets would be as high as $11 billion. It's reasonable to assume that the risk-weighting of capital for those assets was way off, so might not the company have made comparable errors for other assets?

If investors do start to focus on tangible equity instead of other capital measures, as CIBC's Whitney thinks they should, Citigroup's stock could fall even further. Citigroup's stock market valuation of $175 billion is still quite high at 2.7 times its Sept. 30 tangible equity of $64 billion. If Citigroup were to trade instead at a more conservative two times tangible equity, the stock would fall by another 25% from current levels. Citigroup's dividend yield -- the dividend payout of $2.16 per share divided by the stock price -- would then be a whopping 8.2% (it's now 6.2%).

Assuming, of course, there still is a dividend to pay out. As Whitney says, it's hard to make that math add up.