Update: Citigroup Fights for Credibility

December 21, 2023 | Premium Service | We last looked at Citigroup (C) in our post-earnings snapshot in October of this year. With the release of the Q3 2023 bank holding company data by the Federal Reserve Board, let’s see how CEO Jane Fraser is doing on the road to improved operating leverage and equity market valuation. The good news is that the equity market valuation of Citi rallied in Q4 with the interest rate updraft. 

Source: Google Finance

Note that C is in the middle of the pack over the past several months, which is better than being at the bottom of the group with Bank of America (BAC). C picked up almost 10 points of book value since the end of Q3 2023. Why? First came the announcement of layoffs and management buyouts. Then Fraser decided to drop loss-leading municipal bond trading. Most recently, C dropped another loss leader business, ending trading in distressed debt. These moves represent a significant decrease in liquidity in the related markets but are a net positive for Citi in terms of aligning revenue and expenses. 

We start our analysis with a factor that usually comes at the end, namely the return on earning assets (ROEA) for the consolidated company. It might surprise many readers of The Institutional Risk Analyst to know that Citi has a significantly higher level of asset returns than the other top-five depositories. Yet because of above-peer operating expenses and rising funding costs, the net results are decidedly mediocre.  Note that BAC has the lowest ROEA of the top banks. because of the large retained portfolio of COVID-era loans and securities.

Source: FFIEC

Bank asset returns flattened over the past three quarters as the FOMC’s interest rate hikes have reached an effective ceiling. The increase in bank asset yields slowed dramatically over the past year. Fortunately, the rate of change in funding costs also slowed, but Citi's interest expenses are rising much faster than the other depositories, as shown in the chart below. This is another factor contributing to Citi’s poor overall financial performance as shown in the chart below.

Source: FFIEC

The compensation for the higher funding costs is a higher gross spread, which in the case of Citi is today 300bp above the average for Peer Group 1 at almost 6% vs almost 9% for Citi. This higher gross loan spread is why Citi has survived up to this point, yet we must note that a 9% spread is equal to a “B” credit rating from S&P.

Citi has enhanced its gross spread considerably since COVID, another positive achievement for Fraser, yet a higher gross loan spread also means more risk The subprime consumer focus is a legacy of the bank going back to before the early 1980s and Citi’s first foray into global subprime lending. The chart below shows the gross spread on loans and leases.

Source: FFIEC

It was not the Savings & Loans nor the few nonbank mortgage firms that existed in the 1980s, but Citibank N.A. that actually offered one of the first subprime, “no doc” mortgages in the US market. The operational mess that Fraser grapples with today literally goes back decades, but the subprime credit book still generates outsized asset returns that keep Citibank N.A. afloat.

The traditional method used by lenders to assess the credit worthiness of an individual, based on the three C’s of credit (capacity, character, and collateral), were cast off by Citibank in the 1970s under CEO John Reed in order to win new business. By discarding the traditional rules of credit, Citi hoped to create a new market for subprime consumer finance using the loan underwriting techniques of consumer lenders like Household Finance and Associates Corp, which Citi acquired in 2000.

John Reed wrote way back in 1976:  

“We are creating something new. I refer to a fundamentally new business starting with a dedication to the consumer, and to the proposition that we can offer a set of services that will substantially satisfy a family’s financial needs under terms and conditions that will earn the shareholders an adequate profit while creating a healthy, positive and straightforward relationship with the customer.”  

If John Reed almost five decades ago sounds like the head of a fintech lender today focused on buy now pay later, you are correct. There is nothing new in consumer finance, only new faces. The role of Citi as inovator began in the 1970s and ended four decades later in 2008 with the bank’s collapse into government ownership.

Since that event of default, the bank has battled with poor operating returns and a capital structure distorted by the ownership stake held by the U.S. Treasury, which was sold at the end 2010.  A year earlier, Citi agreed to merge its Smith Barney brokerage unit with Morgan Stanley (MS), a bad decision that deprived Citi of a key asset management business going forward.

Today Citi is a three-legged stool, with a subprime consumer lending business, a second-tier capital markets business that is slowly disappearing and a global payments platform, which really is the bank's most valuable asset. In terms of funding, less than half of the bank’s $2.4 trillion in assets is supported by core deposits. As a result, one of the key factors in any analysis of Citi is credit expenses and how credit impacts funding costs.  

Net credit losses at Citi are higher because of the bank’s elevated target default rate for the bank’s portfolio.  Historically, Citi has seen net losses running 3x Peer Group 1 and the other top-five banks, although at present losses are running around 2x the top five bank cohort. We expect to see the differential between net loss for Peer Group 1 and Citi widen as consumer credit losses mount in 2024. 

Source: FFIEC

Notice in the chart above that U.S. Bancorp (USB) and other members of the top five depositories actually saw net losses fall in Q3 2023, a particular example of why the industry saw a drop in credit provision expenses. Yet Citi and other consumer lenders such as CapitalOne Financial (COF) saw loss rates continue to rise slightly. Once the present pause in consumer credit loss rates ends, we look for C and COF to lead the large banks higher in terms of credit expenses. Of note, COF is a monoline credit card issuer that is now just shy of $500 billion in total assets.

Next we look at the bottom line, namely net income vs average assets. The first observation to make is that Citi has been at the bottom of the top-five banks since 2020, when the stock fell off the edge of the table and did not rebound along with the rest of the large bank group. Notice also that Wells Fargo (WFC) has been steadily improving throughout this period. We are looking to add WFC to our portfolio in 2024, hopefully after the momentum-crazed crowd of equity managers retreat from financials, again. 

Source: FFIEC

Lastly we look at operating leverage (aka “efficiency”) and, again, Citi is trailing the rest of the group at 66%.  If you want to state in simple terms what CEO Jane Fraser needs to do to get Citi’s equity market value back into line with its peers, then pushing the bank’s efficiency ratio down into the high 50s is the prerequisite.

At a minimum, we think that Fraser needs to get her bank’s operating efficiency to at or below the average for Peer Group 1, currently at 60%, and keep it there.  Notice that USB is about even with WFC and above Peer Group 1 in terms of efficiency ratio as it digests the acquisition of Union Bank.

Source: FFIEC

Bottom line on Citi is that Jane Fraser is slowly making progress to address some of the immediate and long-term challenges to get the bank back into a competitive position in relation to other large depositories. Because Citi is a higher risk business, it must deliver higher asset returns and superior operating efficiency in order to be credible with investors. We still think that Citi will be forced to merge with another bank as it rationalizes its remaining businesses.

With JPMorgan (JPM) in the low 50% range due to the accounting for the acquisition of First Republic Bank, the bar in terms of operating leverage is set very high. At a minimum, we think that Jane Fraser needs to keep Citi closer to the middle of the pack in terms of asset and equity returns. BAC is likely to be the laggard among the top five banks in 2024 because of poor balance sheet management decisions by CEO Brian Moynihan. If Fraser remains focused on improving Citi's operating results, then BAC could become the very clear problem bank in the group.

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