Citigroup: Breaking Up is Hard to Do

April 22, 2021 | In this issue of premium service of The Institutional Risk Analyst, we take a look at Citigroup (NYSE) in the wake of Q1 2021 earnings and the most recent announcement by new CEO Jane Fraser. In short, Citi announced exits from consumer franchises in 13 Asia and EMEA markets. Citi plans to focus on building wealth management in four centers in Asia, a less than credible strategy in 2021.

Citi reported $7.9 billion in income in Q1 2021, including $3.2 billion in loan loss reserve releases. Excluding the reserve release, which represents revenue earned in 2020, income would have been $4.7 billion. This figure is closer to the true run rate going forward. Remembering that Q1 is generally the best quarter for most banks and financials, so it’s all downhill from here.

There is nothing new in the Citi announcement. Other than the fact of a new CEO, the announcement by Fraser could have been made by any of her predecessors going back decades to John Reed (1967-2000). Citi sold its Smith Barney wealth management business to Morgan Stanley (NYSE:MS) more than a decade ago, thus the announcement by Fraser merely confirms that this was a very bad decision. The table below summarizes the Citi announcement.

While many of Citi’s peers such as MS and UBS Group (NYSE:UBS) have migrated away from capital markets and investment banking, and toward wealth management, Citi has drifted through years of government ownership and weak leadership by the board of directors. It is not that either Jane Fraser or former CEO Michael Corbat are bad managers, far from it. Yet neither are up to the real task, namely selling or breaking up a $2.3 trillion asset bank that no longer has a reason to exist. Ponder the fact that the businesses targeted for exit had a combined efficiency ratio of nearly 80%, meaning that they are barely profitable.

Corbat cleaned up the previous mess at Citi, but lacked the gravitas to tell the board of directors what they need to hear: sell the bank, either as a whole or in pieces. US regulators would probably welcome such a solution to the problem with Citi, a problem that stretches back half a century to the Latin Debt crisis and its messy aftermath. The LDC debt crisis ended up with Citi merging with Travelers under Sandy Weill, a situation not like the merger of Chase Manhattan with JPMorgan after the Penn Square collapse.

The classic Mexico dirty money scandal known as “White Tiger,” which involved Raul Salinas de Gortari and Citibank Private Banking, enabled Weill to eject Reed early on. One day we’ll write the rest of that story. But the key point is that a large money center bank once called First National City mutated into a subprime lender at home and a platform of convenience for the U.S. intelligence community offshore. None of the pieces ever made sense in business terms.

In many ways, Citi in the 1970s and 80s took on the international roles played by lenders such as Manufacturers Hanover and Chemical Bank, both in retail and institutional banking. But the bank never had a compelling or dominant position either domestically or internationally, leading to a franchise that is light on core deposits and very dependent upon market funding like a nonbank. None of the markets marked for exit ever made operating sense for the bank.

Citi did business in a lot of venues around the world, competing with the European and Japanese champion banks for showcase multinational corporate and sovereign business. Yet at home, the nonbank finance company culture of Weill grafted onto the commercial bank, creating a frightening combination of transactional risk and junk grade consumer credit exposure with a gross loan spread far above its peers.

Source: FFIEC

The blended gross spread on Citi’s loans and leases is 7% today, but the spread on the bank’s $200 billion in consumer loans is far higher, a “B” equivalent in terms of the gross spread vs rating agency default scales. But the larger point to make is that less than $700 billion of Citi’s $2.3 trillion in assets is actually in loans, while the rest is invested in securities. The bank has $550 billion in core deposits, but over $650 billion in foreign deposits. The rest is funded off the Street.

Our friend Dick Bove wrote this week that breaking up Citi has been one of his long-held views. We agree. He writes:

The 2008 collapse of Citi illustrates the volatility of the universal bank model. More, Citi has been unable to articulate a strategy for growing shareholder value since leaving government control. Instead, the bank has doubled-down on an unstable mix of global institutional and retail businesses, none of which has even competitive mass in terms of market share. Like its ideal wealth management client, Citi is a seagull with a global reach but no single market upon which to anchor the business.

The subprime consumer business produces nice returns, as does the payments platform, but the investment bank is both a blessing and a curse. Sometimes the investment and commercial banks produce great returns, other quarters they bleed risk.

For instance, in February 2021, Citi announced that a restatement of $390 million due to an increase in operating expenses ($323 million after-tax) recorded within Institutional Clients Group, resulting from operational losses related to “certain legal matters.” The financial impact of this adjustment and restatement lowered Citi’s fourth quarter 2020 net income from $4.6 billion to $4.3 billion.

Like Goldman Sachs (NYSE:GS), Deutsche Bank (NYSE:DB) and, of course most recently, Credit Suisse (NYSE:CS), Citi has a certain idiosyncratic aspect to its risk profile that is impossible to quantify or to ignore. We’ve had a negative risk rating on GS, DB and C for over a year not because of our view of the stock, but rather due to the unknowable aspect of the risk profiles of these universal banks. Add CS to the list.

In a market where the FOMC is literally and without apology sucking duration out of public markets like an insatiable alien hedge fund, stocks obviously must go up, even these financial dogs. But, of course, some stocks go up more than others. The table below shows some of the members of our bank surveillance group. Suffice to say that the book value multiples and credit default swap spreads of these banks have grown or been cut in half, respectively, over the past twelve months. The table below shows the names currently in our bank surveillance group.

Source: Bloomberg

Notice first and foremost that Citi remains below book value despite the impact of QE on global equity valuations. Indeed, Citi is at the bottom of the group in terms of multiple of book value. When you consider that names like GS and Capital One (NYSE:COF) were trading at a significant discount to book six months ago, the lack of performance of Citi is striking and, we believe, begs the question.

Even with the strong quarter in terms of reported revenue, Citi’s efficiency ratio remained at 57%, the poorest operating efficiency among the top five banks. And this ultimately is why the bank still trades below book value even though its asset peers remain at 52-week highs. The poor financial performance is reflected in the pricing for both the bank’s debt and equity. Shrinking the business is unlikely to generate improved shareholder value in the near term due to the expense of exiting these retail markets.

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