Review & Outlook
In November 2019 we published a negative risk profile for Citigroup Inc (NYSE:C), one of the largest bank holding companies in the US at $2.2 trillion in total assets. We reaffirm the negative risk profile, as discussed below.
Comparable Companies
JPMorgan Chase
Bank of America
U.S. Bancorp
Goldman Sachs
Peer Group 1
Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN
We have written a great deal about the modern history of Citibank in The Institutional Risk Analyst, but the bank also is one of the oldest and most political banking organizations in the US. The City Bank of New York first became a depository in 1812 and helped to finance the American war with Britain, essentially acting as the de facto central bank. In more recent years, the bank has served as a convenient outpost for US officials operating in such venues as Vienna, Mexico City, Nairobi and Almaty.
Earlier this month it was announced that Jane Fraser, Citigroup’s president, would replace Michael Corbat as chief executive in February next year. Corbat retires after eight years in the top job. He leaves behind a legacy of stability and rising equity values, but little change in terms of focus or, more important, a new business direction for the bank.
When he joined in 2012, Michael Corbat was the first competent chief executive officer for Citi going back to before 2000. Citi continues to suffer from various operational and regulatory problems, as illustrated by the sanctions imposed on the bank for failing to update its internal systems and controls during Corbat’s tenure. The Office of the Comptroller of the Currency reportedly cited failings related to Citi’s inability to produce timely and accurate reports about the risks on its books, and other infrastructure issues.
Fraser must take the top job after the imposition of a consent order by the Fed and OCC, but truth to tell, Citi has had problems with internal systems for decades, long before Fraser joined the bank in 2004. As the February 2021 transition to Fraser was announced, Sullivan & Cromwell partner Rodgin Cohen told CNBC that Fraser “would be committed to the international strategy.”
In fact, Fraser has no choice but to play the current hand left by Corbat and his predecessors going back to John Reed. The former CEO, who was forced out of the bank in 1998, questioned the structure of combining retail and investment banking—basically, Citigroup’s entire strategy.
“If it were up to me and I had a blank piece of paper, I would segregate the industry into compartments so that you did not have institutions that had both of these functions within them,” Reed told the Wall Street Journal in 2010. Reed observed correctly there was a culture clash when his retail-heavy Citibank N.A. combined in 1998 with Sandy Weill’s Travelers, which was also the home of a high-flying bond shop called Salomon Brothers.
Reed was forced out by the scandal involving Citibank Private Banking and a politically exposed Mexican named Raul Salinas de Gortari. The departure of Reed began a long and chaotic period of weakness in the CSUITE. Reed did not think that Sandy Weill was up to running the company and he turned out to be so right. Weill was forced out by the WorldCom scandal. Of note, Reed said that Chuck Prince, who was Mr. Weill’s legal counsel and eventual successor, wasn’t qualified for the CEO job either.
In 2012, Michael Corbat caught the ball dropped by former CEO Vikram Pandit, who inherited a terrible mess at Citi in December 2007 from Chuck Prince. Sanford Weill’s handpicked successor was forced out following the disclosure of huge losses in Citi’s mortgage portfolio, leaving Citi in turmoil on the eve of the 2008 financial crisis.
Handpicked by Robert Rubin, Pandit’s five year tenure saw Citi’s stock lose most of its value as the bank was slowly dismantled. When Pandit was forced out by the board in 2012, the bank was on the ropes. Over the following eight years, Corbat cut expenses and increased revenue a bit. More important, the stock rebounded during his tenure, but Citi still under-performs other large banks by half because of risks such as funding, loss rates and adverse operational events.
Of note, Fraser ran the bank’s mortgage unit in St Louis, MO, this after Sanjiv Das had stabilized Citi’s run away mortgage correspondent and wholesale lending business. Citi would eventually sell the mortgage servicing book to Cenlar Capital Corp. After cutting back Citi’s overgrown correspondent loan purchasing business, Das went off to start Caliber Home Loans, today one of the best nonbank issuers in the mortgage industry.
In addition to time at the mortgage business, Fraser ran Citi’s problematic Mexico unit, giving her bona fides with the offshore financial community that Citi has served for decades. She also ran private banking, so again Fraser has hands on familiarity with a key business unit. But we do not look for any significant changes or acquisitions in the near term, even though both are badly needed.
Citi is a very political bank. It was a convenient operating venue for former Treasury Secretary Robert Rubin, who spent a decade as political consiglieri to CEO Sandy Weill. Together they created the Citi we know today via a series of nonbank acquisitions. These transactions turned an internationally focused depository into the highest risk consumer lending and subprime mortgage banking franchise of the top-five US banks.
Today, the bank known to the Street as Citigroup is a global institution with relatively little in common with its large cap peers among the top ten US banks by assets, either in terms of asset composition or how it finances these assets. In the US, JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC) and Capital One Financial (NYSE:COF) are the obvious comps. Better offshore investment banking comps for Citi are found in Europe, such as BNP Paribas (NYSE:BNP) or even the struggling Deutsche Bank AG (NYSE:DB), which we have assigned a negative risk rating.
Quantitative Factors
Citi has a global payments and capital markets business, a subprime global consumer lending and credit card business, a commercial lending arm with a weak market presence, and no significant asset management business after selling its portion of Smith Barney to Morgan Stanley (NYSE:MS) in 2012. A century ago the City Bank of New York was a broad line commercial bank funded with domestic deposits. Today Citigroup is a highly specialized offshore bank with little solid anchor in the US deposit market.
Source: FFIEC
The chart above, using consolidated bank holding company data submitted to the Federal Reserve Board and aggregated by the Federal Financial Institutions Examinations Council (FFIEC), shows the relative interest expense differential between C and the 127 banks in Peer Group 1. In Q2 2020, the bank’s interest expense fell twice as fast as did interest income, an illustration of the powerful liquidity benefits of the Federal Open Market Committee’s open market purchases. But gradually asset returns too shall fall.
The banks of Peer Group 1, JPM, BAC and U.S. Bancorp (NYSE:USB) represent the mainstream average business model archetype for large commercial banks. On the other hand, C and COF have higher average loan coupons, higher credit loss rates and also elevated funding costs, much like nonbank consumer lenders. JPM’s equity trades at a multiple to book, while C and COF trade at a discount to book value – and for good reason, namely risk adjusted returns on capital.
Large domestic lenders such as USB have the lowest cost of funds in the group, but C’s cost of funds is 50% higher than the large bank average in Peer Group 1. At the end of the second quarter of 2020, C had more foreign deposits than domestic. About a third of the deposit pie comes from domestic interest bearing funds, a third from foreign interest bearing deposits and a third from repurchase agreements and other borrowed money.
At June 30, 2020, Citi had just $500 billion in core deposits vs $1.1 trillion in non-core funding supporting $2.2 trillion in total liabilities and capital. Citi’s net non-core funding dependence was almost 55% vs an average of 6.8% for Peer Group 1, placing C in the top 5% of large banks in terms of this crucial liquidity measure calculated by the Fed.
Like JPM and GS, C has chosen to enhance returns by using subprime lending and derivatives contracts on and off-balance sheet, creating out sized risk for the enterprise. The chart below shows the relative gross derivatives footings for C and other major banks reflecting both client and firm business.
JPM and Citi are now the two leading derivatives dealers in the world.Total derivatives contracts of $44 trillion notional at the end of Q1 2020 equaled 1,800% of average assets vs an average of 54% for Peer Group 1, putting C in the top four percent of all large banks in terms of derivatives exposure but just half that of Goldman Sachs Group (NYSE:GS).
Source: FFIEC
As a result of the lack of core funding, net loans and leases at C were less than 40% of total assets in Q2 2020, reflecting a predominant focus on capital markets and derivatives dealing activities in terms of asset allocation. That said, Citi took $8 billion in loan loss provisions in Q2 2020 and will likely put a similar amount aside in Q3 2020, although loss trends have been moderate so far this year.
The chart below shows the gross spread on total loans and leases as reported to the FFIEC. As the chart below illustrates, Citi’s gross loan spread is far higher than its peers, but the net results for Citi per dollar of assets are far below that of its far smaller peer.
Source: FFIEC
Although the overall gross yield on C’s loans and leases is 200bp above Peer Group 1, as shown in the chart below, the loss rate on Citi’s loan portfolio is well-above peer by an even larger margin. To us, this is one of the basic reasons why the equity of Citigroup tends to trade at a discount to par and other comparably sized banks.
Source: FFIEC
The chart below shows net income vs average assets for the same group of BHCs. Note, for example, that Citi’s overall asset returns are below those for the hyper efficient USB and JPM. Again, between the outsize risk on the credit book and the poor overall returns, the market position of Citi in the equity markets is no surprise.
Source: FFIEC
When you look at how the marketplace values the earnings flow from JPM vs C, the difference is striking. Citi chronically trades below book value while JPM was just shy of 1.25x book value as this report was finalized. JPM trades on a 1.1 beta in terms of overall market volatility vs 1.8 for Citi. Sadly, the financial media tends to group banks in terms of size only, while frequently ignoring the significant business model differences between one institution and another.
Qualitative Factors
As we note at the top of this report, the fundamental issue when it comes to the qualitative analysis of Citi is the business model. Lacking a leading position in any of the markets that it serves, C is essentially a vagabond, doing business in advanced and emerging markets around the globe but with no dominant market position to serve as an anchor.
C operates a global institutional business in a number of major markets, including North America, Europe, the Middle East and Africa, Asia and Latin America. Citi also operates consumer banking businesses in North America, Latin America and Asia.
Citi is unlike many other large banks active in the institutional markets in that it does not have a significant wealth management business. And no longer does the global trading business lead the way on revenue for Citi, as it did years ago. Instead of the 50/50 distribution between banking and transactions at JPM, at C you see two thirds bank revenue and one-third fee income from the investment bank – this despite the fact that banking assets are less than half of the total.
Robert Armstrong of the Financial Times put the situation into perspective:
“While Mr Corbat declared in 2017 that 'our restructuring is over', it seems likely Ms Fraser will have to reopen the discussion. Yet there appear to be few easy options. Finding a buyer for the international retail assets would be a challenge. Adding scale in the domestic retail operation through a merger would be difficult, given the weakness of Citi’s shares as an acquisition currency — even if regulators would allow Citi to do a large acquisition, which seems unlikely.”
To us, the key qualitative insight regarding C is that the bank takes outsize risks in markets around the globe, and has an unconventional funding base, yet is decidedly mediocre in terms of returns on assets and equity. The market’s judgment has been to keep the equity of C trading below par (we own the C TRUPS). Meanwhile, the legacy management and systems issues that have been a problem at Citi for decades seems to have been the catalyst for the early departure of Michael Corbat and the imposition of consent decree on the bank by the OCC.
It is difficult to argue with the market’s judgment, although we do see analysts frequently try to make a bull case for Citi. Simply stated, the risk simply outweighs the reward at Citi even with the significant expense reductions made under Corbat. And even with almost a ten point advantage in terms of operating efficiency (largely in the area of occupancy expense), Citi still trades at a significant discount to JPM at 1.3x book value today.
Combined with a mix of institutional products offered in various offshore banking venues, Citi has a subprime consumer and credit card business largely focused on North America, but again with global footings. In many countries where C does a consumer business, monitoring individual credit is problematic, adding to the risk profile of the bank’s consumer lending. And the entire consumer book is funded in the institutional credit markets rather than core deposits in the dozens of jurisdictions where C operates.
The need to acquire and retain core funding is another piece of the puzzle and contributes to a very competitive situation for Fraser in the institutional market. This is one reason why more disciplined organizations such as number five money center USB work hard to maintain a certain assets size rather than weaken loan pricing in the name of short-term portfolio growth. Citi was terribly guilty of this in the 2000s, when the bank opened the floodgates to correspondent residential lending in competition with the likes of Countrywide Financial and eventually failed when investors demanded redemption of subprime securities.
To paraphrase Jim Grant’s observation about Fed Chairman Jerome Powell, Citigroup’s new CEO Jane Fraser, like Michael Corbat before her, is a prisoner of history. Fraser did not pick the mix of businesses that are now part of the firm’s product bundle, but she does not have any easy choices to change things short of a combination with another bank.
With the C stock trading at or below book value, the bank is in better shape than DB, but lacks a strong currency to use for acquisitions. And most of the large, internationally active banks that C could acquire have problems of their own. Suffice to say that the Fed’s Board of Governors would never countenance a transaction involving Citi that did not eliminate the possibility of the bank requiring another government rescue down the road.
Assessment
Our overall assessment of the quantitative and qualitative factors behind Citigroup is negative. The bank under-performs its peers financially, takes outsized risks compared to its large bank peers, and has no clear strategy for improving asset returns, access to funding or the bank’s overall risk profile.
The bank operates in over 160 different countries and jurisdictions, multiplying its financial and operational risks. And Citigroup continues to be the largest single bank dealer in derivatives, both on and off-balance sheet, again adding another dimension of risk to the overall analysis. Consider the short-list of challenges facing C:
Asset returns: C significantly underperforms its peers in terms of asset returns, efficiency and loss rates. Compared with industry leaders such as AXP, Citigroup significantly underperforms when it comes to dollar of income per dollar of assets. Remarkably, the fact of C’s significant off-balance sheet derivatives exposures does not improve the overall financial performance of the bank.
Funding: The cost of funds for C is significantly higher than for most of the bank’s US asset peers. More, the fact that just one quarter of the bank’s funding comes from core deposits is a reason for concern in the event of heightened market volatility. One of the key factors that must change in order for C to improve its financial performance is to access more stable, cheaper sources of funding. Most of the banks that have solid core funding, however, trade at a significant premium to C.
Growth: Many if not all of the market segments addressed by the bank are already overbanked. The fact that the US Treasury chose to rescue Citigroup rather than break up the bank a decade ago has left a significant amount of over-capacity in institutional capital markets. Since political leaders in the industrial nations are loathe to liquidate poorly performing banks such as DB or HSBC, the likelihood is that C will continue to muddle along until such time as it is forced to combine with another bank, likely under less than attractive terms for shareholders.
Unless and until the management team led by Corbat and eventually Jane Fraser finds a way to enhance the bank’s financial performance and/or funding, we expect the bank to continue to underperform its asset peers in terms of market valuations. Superior operating leverage achieved under Corbat is commendable, but not sufficient. We believe that a change in the operational path of C is unlikely to occur in the near term and is only likely to occur at all as and when regulators compel a combination with another large bank.
Bank Group: AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC
The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.
Comments