Remember the part of the movie "Fantasia" where Mickey Mouse, the sorcerer's apprentice, uses magic to get a broom to carry water for him, but then can't get it to stop? Put yourself in Mickey's shoes, and you understand how John Reed, chairman of Citicorp, must feel when he contemplates Citicorp's auction-rate preferred stock.
This is a sophisticated security bought by corporations. Its dividend rises and falls every 49 days or less at so-called investor auctions. It was a great idea once, but now it's become an expensive menace -- and as Mickey discovered, it's not so easy to turn off once you start it up.
When Citicorp, the country's biggest bank company, first peddled auction-rate preferred five years ago, the stock was as magical as Mickey's broom. Thanks to a loophole in the tax code, the preferred gave Citicorp very cheap money while giving the stock's owners a very high return. It was so popular that Citi peddled 10 different issues totaling $950 million.
But those glory days are gone, with Citicorp in financial trouble and investors demanding and getting junk-like 13 percent dividends to buy the preferred. Not only is the preferred costing Citicorp money it can ill afford, but also it has begun generating dangerous publicity, which it also can't afford. Every time an auction is held and Citi has to pay a usurious rate, it produces more bad press on investors' doubts about Citicorp.
So why doesn't Citicorp just buy back the preferred stock with the billions of dollars of credit it says it has available? Money that would cost less than 13 percent?
The official answer is that Citicorp doesn't want to be driven out of any market for capital. The real answer, I think, is that preferred stock counts as capital under bank holding company rules, but borrowed money doesn't, and Citicorp doesn't want to lose any capital, no matter how expensive.
Capital is the money banks must keep on hand to cushion themselves against hard times; you compute the ratio of capital to assets to determine whether the bank is sound. Replacing $950 million of preferred with $950 million of borrowed money would reduce that ratio, which wouldn't exactly thrill Citicorp's regulators.
How does money costing 13 percent get to be considered capital? The answer, to oversimplify, is that Citicorp issued this stuff with a promise to pay dividends at the going rate, which is determined at an auction every seven weeks or so. Unlike a bond or note, however, this security has no due date -- it's called a perpetual issue. That means you can't demand your money back from Citicorp (and that is why the company can count the stock as capital). If you're holding the stuff and want to get rid of it, you have to hope someone buys it from you at one of these auctions.
The short-term risk is that if there are no buyers, your short-term investment could turn into a long-term one. The long-term risk is that regulators will strip Citibank from Citicorp, making it difficult if not impossible for the holding company to pay its bills, including the dividend on your preferred stock. In that case, your short-term investment would turn into a long-term disaster.
Before we go any further, you need to remember that Citicorp isn't Citibank, and it's important not to confuse the two. Citicorp, which is the issuer of the auction-rate preferred stock, is a bank holding company. Citibank, the nation's largest bank, is Citicorp's main subsidiary.
Even though I think Citicorp could some day stiff some or all of its creditors -- an opinion that Citicorp vigorously disputes -- I don't think that Citibank will stiff depositors, even those whose accounts aren't fully covered by the Federal Deposit Insurance Corp. The reason: The FDIC's too-big-to-fail doctrine, under which the FDIC protects all of a giant bank's depositors, including those with accounts greater than the $100,000 maximum that the FDIC insures. The reasoning is that an uncontrolled collapse of a giant bank could ruin the nation's economy, if not the entire world.
But too-big-to-fail, as FDIC Chairman William Seidman said in an interview, covers banks, not the holding companies that own the banks. The difference is crucial. Three times now -- when it put big, busted Texas institutions to sleep -- the FDIC has tried to strip holding companies of their banks so that the depositors are protected and holding company stockholders and creditors get wiped out.
Which brings us back to Citicorp and its run-amok preferred. The stock owes its very existence to a loophole in the federal tax code. Corporations that collect dividends can exclude 70 percent of them from federal tax under most circumstances. Interest, by contrast, is fully taxable. Do the math, and you see that to a corporation, a 10 percent preferred stock is as good as a 13.5 percent bond.
In this case, Citicorp's 13 percent dividend gives a corporate owner the equivalent of an 18.5 percent bond. Which is why corporate treasurers keep buying this stuff even though it's risky.
The risk of getting stuck is more than theoretical. After Shearson Lehman Brothers Inc. bought some MCorp auction preferred to keep the auction illusion alive, Shearson got stuck holding paper of a bankrupt company. Holders of Lomas & Nettleton auction-type notes were similarly burned.
Some other bank companies that, like Citicorp, are in not-such-wonderful shape have redeemed their auction-rate preferred. These include the parent companies of Manufacturers Hanover, Mellon Bank and First Interstate.
Citicorp wants people to think it will call in the preferred soon if rates on it don't drop. We'll see. But if all else fails, John Reed can try what Mickey did in "Fantasia." Which is to scream loud enough to buy enough time for a wizard to bail him out.
Allan Sloan is a columnist for Newsday in New York.