Outliers: CapitalOne, Goldman Sachs & Citigroup

December 20, 2022 | Premium Service | A couple of readers have asked questions about some of the more volatile banks in the group, particularly Goldman Sachs (CS) and Capital One (COF). These are two specialty banks that are long on market and credit risk and short on stable core deposit funding. Add to the list Citigroup (C), a mostly offshore, two-legged stool of a global bank with capital markets married to consumer finance, but no asset management to add stability. This ragged band of misfit toyz comprise the outliers on our bank surveillance list as 2022 ends.

COF is an obvious outlier because it is basically a national monoline credit card issuer with some purchased retail and commercial deposits. The probability of default P(D) for COF has doubled since November to 165bp or 2x JPMorgan Chase (JPM). The equity is down 40% YTD and is trading at ~ 0.7x book value. Most of the large banks have seen CDS spreads widen as equity prices have fallen.

As of Q3 2022, COF’s cost of funds was more than 2x Peer Group 1. COF makes up for this differential because the yield on its loan book is almost 10% vs 4% for the banks in Peer Group 1. Net loans losses were 1% vs less than 0.25% for most large US banks in Q3 2022. That may seem like a lot, but we can recall when COF peaked at 11% gross charge-offs in 2009 and yet survived.

The loss given default number in Q4 2009 for the whole US banking industry was 3% net loss after recoveries, which gives you a sense of the risk on COF’s book at 11%. In Q3 2022, COF’s provisions for loan losses were up 54% YOY to $1.6 billion. The chart below shows the net loss rate for the outliers along with the average for Peer Group 1.

Source: FFIEC

As you can see in the chart above, COF has a higher net loss rate than the rest of the group. The top five money centers are well below the loss rate for GS, which we discuss below. That high loss rate is why the $440 billion asset COF has 12% capital and sufficient earnings coverage to absorb significant losses. And the good news is that COF’s core deposits, while expensive, have remained stable abound $300 billion for the past five years.

When we next move on to Goldman Sachs, the picture is more troubled. GS has a credit loss rate 2.5x Peer Group 1 and far above the rest of the Wall Street group, who generally don’t take credit risk. GS manages to lose more money on loans per dollar of assets on a smaller book than its larger peers. The CDS spreads for GS are wide of JPM and the other money centers at 100bp, but the firm trades on a > 1 beta, illustrating the low volume in GS vs peers.

The investment banking firm had pre-announced significant headcount reductions as well as caps on bonuses for the survivors. Part of the reason for this austerity is that like most nonbanks (and GS is predominantly a nonbank), volumes are falling and funding costs are rising. In fact, GS has higher funding costs that does Capital One or Citi on a consolidated basis and 300% of the average for Peer Group 1.

Source: FFIEC

Notice that Goldman is leading the outliers up in terms of funding costs, even above that of both Citi and COF. This is a remarkable distinction. While COF had good core deposit coverage of assets, Citi is still one-third offshore funded and yet still has lower funding cost than GS. When you put the planned layoffs at GS in the context of a company that is seeing its cost of doing business rise while revenue falls, then you understand the dilemma facing the CEOs of every nonbank finance company in the US.

The next factor in the analysis in terms of these companies as lenders is the gross spread on the credit book. The chart below shows that COF has significantly more spread on its book that do either Citi or GS, but it also has commensurately higher credit losses. The earnings power that Citi and COF have in their double-digit yield on their credit card books makes up for a lot of sins, but rising costs for loss provisions are already starting to take a bite out of earnings. Notice the poor pricing of the GS loan portfolio during COVID.

Source: FFIEC

All of the financial metrics come together in net income, which is shown below as return on assets. Notice that Citi has the poorest performance in the group and has done for some time, a clear indication of the factors behind the bank’s poor performance in the debt and equity markets. Citi is currently trading below half of book value and is just below 100bp in CDS. GS is second from the bottom and below the average for Peer Group 1, another remarkable achievement.

Source: FFIEC

All of the outliers display the upward skew in income in 2021 due to COVID and the period of massive bond purchases by the FOMC. Now as credit costs and interest expense normalize, these firms and indeed all financials will be giving back capital to offset operating losses due to falling volumes. This trend will place increasing weight on operating efficiency, as shown in the table below. Notice that COF has a several point margin in terms of operating efficiency.

Source: FFIEC

Not only does COF have better operating efficiency than most of the banks above it in size, but the consumer lender has a very small footprint in the casino of OTC derivatives. While GS and Citi have derivatives books that are thousands of percent of total assets, COF is in line with the average for Peer Group 1. That is why, for our money, if push comes to shove, we like COF’s market position and liquidity better than Citi or GS.

Source: FFIEC

Ponder the fact that Goldman Sachs feels the need to maintain an OTC derivatives book that is 2,500% of their total assets of $1.5 trillion. Indeed, GS has the largest derivative book on Wall Street.

We own the Citi TRUPS and preferred from some of the other larger banks, but continue to stay away from the common. All of these banks are likely to spend capital over the next year or two as the long strange journey know as quantitative tightening continues. Fact is, long-term interest rates have been falling for the past several months, but we think that trend is likely to reverse in the New Year.

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