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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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Citigroup: Expanding Multiples, Flat Margins

New York | We start the week in downtown Manhattan with a presentation to the International Association of Credit Portfolio Managers in New York (click here to download slides). We’ll refer to some of the slides in the comments below. And we appreciate the feedback about last week’s comment about the role of Equifax and the other consumer credit agencies in the mortgage market.

Of note to one reader’s question, lenders do not need a FICO score to submit a mortgage to the federal housing agencies for insurance, but the GSEs do require all three raw credit reports be pulled into a “Tri Merge” file as part of the underwriting process.

And by no surprise, the consumer credit bureaus also have credit scores or their own. The competition between FICO and the three credit repositories is a glorious race to the bottom in terms of credit scores for mortgages. Suffice to say we’ll be coming back to the question of credit scores in the context of mortgage lending soon.

Got a cheery missive from Jerry Flum at Credit Risk Monitor (OTC:CRMZ): “Debt is at its highest levels since 2007, and with interest rates near their all-time low, there’s reason to be concerned about the amount of risk growing in your public company customer and vendor portfolios.” They add: “Corporate debt is becoming excessive…”

Of course, Jerry is preaching to the choir when it comes to our appreciation of America’s migration towards national insolvency. To review, there are three phases of indebtedness, this progression codified by our friend Bill Janeway in a November 17, 2008 issue of The Institutional Risk Analyst kindly republished by Barry Ritholtz.

The first phase is solvency, then mere liquidity sustains the growing debt, and finally default results when both interest and principal must be borrowed or "rolled." Janeway noted regarding the creation of “the largest pile of leverage the world has ever seen” via the birth of financial economics:

“The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable.”

Part of the reason that the US economy is growing more slowly now than in the Roaring 2000s is that the amount of leverage on private capital from banks has actually been reduced by the forces of the progressive oversight.

The other day, we heard Mike Mayo, now of Wells Fargo Securities BTW, wax effusive on Citigroup (NYSE:C). The common stock of this zombie money center bank has moved up over 20% in the past year, trailed by JPMorgan Chase (NYSE:JPM) at +8% and Goldman Sachs (NYSE:GS) barely registering positive movement.

But the thing to keep in mind about Citi and all of the big banks is that the ways of expanding actual profit margins are few. We are witnessing multiple expansion in the stock prices of financials, but no margin expansion to validate the higher equity market valuations. With a gross loan spread of 6.42% vs 4.40% for the large banks in Peer Group 1, Citi does have a higher return on assets but with a higher cost of funds, mostly in deposits raised from institutional investors.

The notion that somehow larger banks are going to develop pricing power in the current loan market is kind of laughable. Loan margins have been under pressure for years, so even if the Federal Open Market Committee could make market rates go up, slack volumes in new C&I lending suggest that pricing dynamics could get even more competitive. The chart below from the St Louis Fed’s FRED system illustrates the slowing in new commercial lending.

Part of the issue here is that magical notion known as macro-prudential regulation. Even as the FOMC and other world central banks have been busily purchasing trillions of dollars worth of private securities to encourage investment, bank rules have effectively lowered loan-to-value or LTV ratios. Bank borrowers must have more skin in the game, which lowers the leverage on private capital throughout the US economy.

Home builders, for example, must have more equity in deals compared to the 2000s. Today a homebuilder must have 50% equity in a deal for a 50 LTV loan instead of 30% capital in a 70 LTV loan. As George Gleason of Bank of the Ozarks (NASDAQ:OZRK) told us, he has less leverage on his book than he did decades ago. Prospective short sellers please take note.

The result of regulation is less growth, but lower loan default rates and, at least partly, improved recovery rates for banks. But the other obvious effect is lower levels of economic activity. This is the pound of flesh extracted by supporters of the Dodd-Frank law in their crusade against Wall Street excess.

Even as global bank regulators try to reduce leverage levels inside bank portfolios, the FOMC is engaged in a massive experiment in social engineering to encourage borrowing and investment by keeping rates artificially low. The Fed bought almost $2 trillion mortgage bonds to help the housing market, this even as prudential regulators discourage lending on construction and development loans. Indeed, C&D lending is perhaps one of the greatest opportunities today in financials.

In Washington, one hand does not know what the other hand does. Fed Chair Janet Yellen expresses puzzlement about inflation, but clearly the lower levels of leverage on capital in the US banking system seemingly provide part of the explanation. A home builder can start three new homes at 70 LTV, but can support only two new housing starts at 50 LTV. Hmmm.

Meanwhile back to Citi, we love to hear analysts talk about margin expansion at a bank with “stable funding” that is two-thirds foreign deposits, placing the bank in the top quintile of banks in terms of funding costs. The bank’s premium cost of funds is almost 2x the 43bp average for Peer Group 1.

And did we mention that the bank’s return on earning assets is actually lower that its large bank peers? Even with the high-yielding returns on Citi’s subprime consumer book, the bank’s paltry overall yield on earning assets is a function of low returns on the bank’s business loans.

With the large US banks as a group and Citi in particular, there ain’t no leverage pickup apparent in the latest financials. The all-important factor of loan demand is constrained by the idiocy of macroprudential regulation. This will not prevent Sell Side managers from bidding up Citi and other large caps, however, because quite simply there is nothing else to buy. Kudos to Pete Najarian for holding his ground against the bull stampede into financials.


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