Citigroup: Collateral Damage from Bank of America
Sep/111
This is the second of a three part posting on Citigroup. The first part explored how I own Citigroup and other large banks despite the risk of a systemic collapse if there was a hard Greek default. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Bank of America has been in the headlines about its mortgage exposure and capital situation. Its stock is down 42% this quarter through September 23rd, but Citigroup, which I do not believe has similar problems, is also down 40%. In fact, the two stocks seem to be perfectly correlated. It appears that investors are making macro trades against the banking sector without doing fundamental research on the individual companies within the sector. I do not know whether investors are just scrambling to hedge exposures using any bank stock they can find or whether they are expressing their views mainly through sector ETFs. However, good stock pickers appear to have an opportunity within the banking sector since the stocks have moved in such close correlation during the quarter.
I have been adding to my Citigroup position at recent levels. It has a tangible book value of $48.75 as of June 30th, but is trading around $25, or at about 50% of tangible book value. It trades at this discount to book value in spite of reporting profits the last six quarters, having improving credit metrics, building capital, an improving its business mix, and potentially beginning a stock repurchase program next spring.
Bank of America trades at a similar 50% of June 30th tangible book value despite what I perceive as having much higher uncertainty about legacy mortgage costs and having recently diluted common shareholders through the preferred stock and warrant sale to Berkshire Hathaway announced in late August.
It seems to me that Citigroup is being unfairly tarnished by Bank of America’s problems and is a better stock to own at the same valuation. An investor could own Citigroup and short Bank of America as a hedged pair trade. I own both stocks, but my position in Citigroup is much larger than my position in Bank of America.
A Classic Turnaround
I believe Citigroup has all the ingredients of a classic turnaround situation. A large conglomerate with an iconic brand performs poorly because it has become too unwieldy to manage. A new CEO comes in and implements a new strategy to exit non-core assets and businesses. The capital generated from the asset sales has been earmarked for share repurchases. The remaining core businesses operate more profitably and grow faster than before because management can now focus resources on these businesses.
Citigroup’s CEO Vikrum Pandit is executing this turnaround. It has been more difficult than normal because of the difficult economic environment, the need for government assistance at the height of the credit crisis, and the massive size of the organization. That being said, it appears from the outside that things are on track. Management has split the company into two segments: one segment (named Citicorp) holds the company’s three core businesses and the other segment (named CitiHoldings) holds various businesses and assets that Citigroup management has decided they no longer want to own. The assets in CitiHoldings have been declining steadily (see slide 13 on Citigroup’s 2nd Quarter Earnings Presentation.) Although I have thought that Citigroup has given up too much value during some of the asset sales, the management has made steady progress with the asset sales.
I project that Citigroup will generate about $15 billion of excess capital over the next two years. I expect the main source of the excess capital will be from the proceeds of asset sales from the wind down of CitiHoldings. Plus, I estimate that Citigroup will generate more capital than required for growth of its core business. The final piece of the turnaround may come by April 2012 when I expect Citigroup will get approval for a stock buyback program with the excess capital it has generated in 2011. Of course, this approval will be dependent on the operating environment and Citigroup’s results and regulators assessment of Citigroup’s capital and risk positions.
After exiting most of the assets in CitiHoldings and hopefully shrinking the outstanding share count substantially, I believe that investors will be attracted to the remaining Citigroup businesses which are currently in the Citicorp segment. These three businesses are the global retail bank, the corporate bank and institutional securities unit, and the transaction processing business. I believe these remaining three businesses are all good franchises and have the ability to produce attractive growth and returns for shareholders. The corporate structure should be much simpler to understand and analyze.
Global Retail Bank
Of the three core businesses within Citigroup, I believe the global consumer banking franchise is the most attractive business and a unique world-class asset. In my opinion, Citigroup has the only global consumer banking brand with possibly only HSBC as a distant #2. This positions Citigroup for better long-term growth prospects than its U.S.-centric peers (BAC, WFC and JPM.)
The global nature of the Citigroup’s consumer banking franchise positions it for better loan growth than a typical domestic bank. The retail bank benefits from the fast growing economies of the emerging markets. Plus, Citigroup has the option to redirect resources to or from any particular market based on whether that market’s prospects are attractive. With stronger economies outside the U.S., I believe Citigroup’s consumer banking franchise will generate attractive profits and growth and investors will one day give it a premium valuation compared to its domestic peers like Bank of America.
Comparison to Bank of America
I believe Citigroup should trade at a premium to Bank of America because it doesn’t have the same legacy mortgage and capital issues that I believe have been pressuring Bank of America’s stock in Q3. Here’s a look at some statistics that directly compare the two companies:
| Citigroup | Bank of America | |
| YTD Repurchase Provisions | $352 million | $15 billion |
| Mortgage Servicing Portfolio | $571 billion | $2,003 billion |
| Delinquency Rate in Loan Servicing | 8.1% | 13.7% |
| P/E 2012 | 5.0x | 5.2X |
| P/TB | 50% | 51% |
| Market Cap | $75 billion | $64 billion |
| P/E 2012 | 5.0x | 5.2X |
Source: SEC filings, Yahoo! Finance
I believe that Bank of America’s mortgage issues are an order of magnitude worse than Citigroup’s. Bank of America, including its acquisitions of Countrywide and Merrill Lynch, originated a higher amount of the mortgage loans in the worse vintage years of 2006-2008. Bank of America has realized more mortgage losses so far in 2011 than Citigroup, and it has a mortgage servicing portfolio almost three times the size of Citigroup’s.
Do You Believe the Bond Market or the Stock Market?
The bond market is telling us that Citigroup’s stock is undervalued. Ed Najarian, Head of Bank Research at the ISI Group, wrote an interesting note earlier last week showing the strong relationship between the major banks’ Price-to-Tangible Book ratio compared to where their CDS spreads are trading. Wells Fargo and JP Morgan trade with the tightest spreads and the highest P/TB ratios. At the other end spectrum, Bank of America and Morgan Stanley trade with the widest spreads and the lowest P/TB ratios. In the middle, Goldman Sachs and Citigroup trade with CDS spreads about equivalent to each other. Goldman’s P/TB ratio is perfectly between JPM and WFC on one end and BAC and MS on the other. The interesting part is Citigroup doesn’t have a P/TB close to Goldman’s; rather, it has the same P/TB as Bank of America and Morgan Stanley, which both have wider spread levels.
As of 9/20/11:
| P/TB | CDS Spread | |
| WFC | 1.40x | 126 bps |
| JPM | 1.03x | 127 bps |
| GS | 0.84x | 233 bps |
| C | 0.55x | 231 bps |
| MS | 0.57x | 320 bps |
| BAC | 0.55x | 339 bps |
Source: Bloomberg, SEC filings
As a believer that the bond market is collectively smarter than the stock market, I believe the bond market’s assessment of Citigroup’s risk is more accurate, and Citigroup is undervalued by the stock market.
Citigroup is a classic turnaround. They are selling non-core assets and I expect the management to use the proceeds to repurchase stock at attractive valuations. I believe the core businesses within Citigroup, especially the global consumer bank, appear attractive and could generate high levels of profitability and growth than their U.S.-centric peers. I believe investors are unfairly penalizing Citigroup for Bank of America’s woes.
Disclosure: Long C, BAC, MS, WFC
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Hank Paulson Isn’t Operating His Financial Doomsday Machine
Sep/110
Current events in the financial markets have eerie similarities to 2008: looming defaults of large formerly riskless debt issuers, toxic debt that needs to be written down, elevated LIBOR rates, etc. The major difference is the current U.S. Treasury Secretary is committed to keeping the financial system functioning.
We all watched in horror as the events of September 2008 unfolded. Investors had been nervous all summer about the stability of the major financial firms. As we entered September, there were a couple of lingering issues (Lehman Brothers and the GSEs), but both had reasonable outcomes. In fact the markets were not signaling financial distress as the CBOE’s VIX Index entered the month at a reasonable 20.65.
First, Lehman Brothers was clearly in need of capital given its massive real estate exposures. Although it seemed unlikely they’d be able to raise additional capital, it was reasonable to assume a controlled sale of the firm similar to the Bear Stearns sale in March 2008 would transition the business to an acquirer. Since Bear Stearns bondholders were made whole, the financial system kept chugging along. The same could happen with Lehman.
Second, Fannie Mae and Freddie Mac were under pressure mainly because of their mortgage exposure and their political opponents sensed weakness and continued to pressure the companies through the media. The chatter was the GSEs were starting to pay higher rates on their weekly discount note auctions, but this was a not event because both companies had $700 billion of unencumbered debt that any repo lender would take as collateral. Plus, the situation seemed to be resolved over the summer with new powers for the Treasury Secretary to be able to inject capital into the firms, which he said he didn’t intend to use.
Instead of riding through a tough market, Hank Paulson turned on his Financial Doomsday Machine. Economist Anatole Kaletsky coined the term in a September 18, 2008 op-ed in The London Times:
“It is clear that most of the actions taken recently by regulators and governments have exacerbated the crisis. Instead of using his Government’s unlimited financial firepower to defend the financial system, Henry Paulson, the US Treasury Secretary, turned his guns on his own side, wiping out long-term investors who tried to support leading financial institutions, while rewarding speculators who tried to bring them down.
Mr Paulson was activating a financial Doomsday Machine, driven by a chain reaction of actions by stock market speculators, regulators, credit-rating agencies and accountants. The details of this mechanism are complex, but the gist is simple – if a bank’s share price falls below a critical level, its credit is downgraded; it has to sell assets at fire-sale prices; this further weakens its capital, leading regulators to question its solvency; this drives down its share price and the vicious circle takes another turn. What Mr Paulson did ten days ago was to hand to stock market speculators the key to this Doomsday machine.
This may seem an outlandish accusation – especially against a supposed financial mastermind who was a chairman of Goldman Sachs – but consider the event that triggered the market attacks on Lehman Brothers, AIG and HBOS. They all followed Mr Paulson’s punitive decision on September 7 essentially to expropriate the $20billion of capital injected into Fannie Mae and Freddie Mac by shareholders over the previous 12 months. Long-term shareholders made these investments, with the encouragement of the US Government, to stabilise Fannie and Freddie. Meanwhile, a host of short-term speculators were selling these same securities, convinced that the two companies would be driven into bankruptcy.
By rewarding short-sellers while wiping out investors who reckoned on a long-term recovery that would restore the mortgage giants to profitability, Mr Paulson sent the clearest possible message to financial markets around the world. Any investor who puts money into a US financial institution that might run short of capital would have it expropriated by the US Government. On the other hand, sellers of US bank and insurance shares would be richly rewarded if they could destabilise any financial institution sufficiently to force it to turn to the Government for help.
In the past few days the same pattern of perverse incentives has been repeated in the bankruptcy of Lehman and the “rescue” of AIG. In both cases, Mr Paulson decided to wipe out investors banking on a recovery while rewarding destabilising short-sellers.
The key question is whether this scorched-earth strategy will become a firm principle of Mr Paulson’s responses to future attacks on US financial institutions.”
Paulson committed the largest financial policy mistakes since the Great Depression by placing the GSEs into conservatorship and forcing Lehman Brothers to declare bankruptcy. Paulson had destroyed the potential for a private recapitalization of the banking system with his actions. The financial system quickly froze. Money-market funds stopped purchasing new commercial paper. AIG needed a massive bail-out two days later. Goldman Sachs and Morgan Stanley needed to obtain bank charters over a weekend. All of these events lead to the Great Recession as Main Street American consumers and business people started conserving cash and restrained their spending.
Back to the events of today, the current U.S. Treasury Secretary, Tim Geithner, is on a different course from Paulson circa Labor Day 2008. He was the New York President at the time and sat at the table watching Paulson make his mistakes. I see from his speeches and interviews that he will protect the financial system. I believe that he will not let major U.S. financial institutions such as Citigroup and Morgan Stanley get destroyed in a chain reaction to a default in Greece. The difference between Geithner and Paulson is why Greece will not be the equivalent of Lehman Brothers for the U.S economy.
Texas Capital Bancshares: Credit Trend is Not Good
Aug/100
Texas Capital Bancshares (TCBI) is an interesting organic growth banking story, but the bank’s declining credit metrics make it a better short from here. The bank is 12 years old and has grown by lifting out relationship bankers from the big banks. These relationship bankers bring their best customers over to TCBI. This is an efficient and capital friendly growth strategy. This strategy also allows the bank to grow even in periods of weak loan demand.
However, the credit metrics of the bank have deteriorated significantly over the past 4 quarters. The only potential catalyst that matters is a sign stability in the bank’s credit metrics. The next data point won’t be for another 7 weeks when the bank releases Q3 numbers.
Here’s a look at the credit numbers for TCBI
| 2009 Q2 | 2009 Q3 | 2009 Q4 | 2010 Q1 | 2010 Q2 | |
| Loans Outstanding | $4,211 | $4,290 | $4,457 | $4,443 | $4,463 |
| Loan Loss Provision | 11.0 | 13.6 | 10.1 | 13.1 | 15.7 |
| Net Charge-Offs | 6.8 | 2.8 | 8.0 | 9.3 | 12.6 |
| Loan Loss Reserve | 54.3 | 65.8 | 67.9 | 71.7 | 74.9 |
| Non-Accrual Loans | 49.6 | 85.3 | 95.6 | 115.9 | 138.2 |
| Other Real Estate Owned | 31.4 | 34.7 | 27.3 | 28.9 | 42.1 |
| Non-Performing Assets | 81.0 | 119.9 | 122.9 | 144.8 | 180.3 |
| Non-Accruals/Loans | 1.18% | 1.99% | 2.15% | 2.61% | 3.10% |
| Reserves/Loans | 1.32% | 1.54% | 1.55% | 1.63% | 1.68% |
| Reserves/Non-Accruals | 109% | 77% | 71% | 62% | 54% |
| Tangible Common Equity | 456 | 466 | 473 | 491 | 504 |
| Texas Ratio | 16% | 23% | 23% | 26% | 31% |
TCBI’s numbers are showing a disturbing trend. Non-accrual loans have accelerated the past two quarters. Plus, it looks like management has not been adding to the loan loss reserve aggressively as non-accruals have climbed.
One could argue that TCBI has been under reserving for loan losses during the past 4 quarters. The loan loss reserve to non-accrual loan ratio has declined from 109% to 54% over the past 12 months. If management had kept this ratio constant, TCBI would have report a losses instead of profits over the past 4 quarters.
TCBI shares trade 1.15x tangible book. I think the profitability of the bank is questionable given the declining reserve ratios. If you add in the worsening credit metrics, I think TCBI will have a lid on its stock price until it reports a quarter with stable credit metrics. Since TCBI is well-capitalized, the viability of the bank is not in question. But, the decline in the credit quality suggests that the credit issues are open-ended. I think investors should demand a discount to book value to own a bank stock with credit quality continuing to worsen at rate like this. At 70% of tangible book, the stock would trade at $9.50 or a decline of 35% from the current price.
Paul Pilecki Moves to Kilpatrick Stockton
Feb/100
Paul Pilecki moved to a new law firm, Kilpatrick Stockton, last week. He specializes in bank regulatory law. If you know any bankers who need help dealing with their regulators, Pilecki can help them. Here’s the press release from Kilpatrick:
Kilpatrick Stockton’s Financial Institutions Team Adds Prominent Partner
WASHINGTON, DC (February 16) – Kilpatrick Stockton announced today that Paul S. Pilecki and Michael A. Mancusi have joined Kilpatrick Stockton’s leading Financial Institutions Team. Mr. Pilecki and Mr. Mancusi, who will be resident in the Washington, DC office, are joining from Winston & Strawn.
“We are thrilled to have attorneys of Paul and Michael’s caliber join our nationally-recognized practice serving the financial services industry,” stated Paul Aguggia, Chair of Kilpatrick Stockton’s Financial Institutions Team and Member of the Executive Committee. “Their combined practice, which provides deep bank regulatory expertise for both top foreign and domestic banks, is a perfect complement to our existing practice and will provide clients with another outstanding resource. Their expertise will help keep Kilpatrick Stockton on the cutting edge of this constantly changing area of law.”
“Michael and I are excited to join one of the leading practices in bank M&A and capital transactions,” stated Mr. Pilecki. “The Kilpatrick Stockton Financial Institutions Team is well-positioned for what should be an active period in corporate transactions in the banking industry.”
Paul S. Pilecki concentrates his practice in the representation of foreign and domestic banking organizations on regulatory and corporate matters, and has extensive experience in helping banking organizations plan new activities and corporate structures for their U.S. activities.
Mr. Pilecki’s experience includes matters under the Bank Holding Company Act, the Federal Reserve Act, the Federal Deposit Insurance Act, the International Banking Act, and other federal and state banking and securities laws. He also represents financial institutions on supervisory and enforcement matters, including conducting internal investigations, fashioning remedial programs, and advising on compliance with formal enforcement actions and supervisory agreements. Mr. Pilecki advises diverse clients on compliance with the Bank Secrecy Act and implementing anti-money laundering and anti-terrorist financing measures. He has served as an expert witness on bank regulatory issues, including matters under the Bank Holding Company Act, the Edge Act, and the Bank Merger Act. Mr. Pilecki began his professional career as a bank examiner for the Federal Reserve Bank of Philadelphia and was a member of the Legal Division of the Federal Reserve Board in Washington.
He currently chairs the Executive Council of the Federal Bar Association’s Banking Committee and is an active member of the International Banking Subcommittee of the American Bar Association’s Banking Law Committee. Mr. Pilecki is a contributing author to the multi-volume treatise Banking Law and is a frequent speaker on bank regulatory issues. He was named a Client Service All-Star for the second time in 2010 and is included in Who’s Who of Banking Lawyers.
Michael A. Mancusi represents foreign and domestic banking organizations in regulatory, compliance, and enforcement matters, and has substantial experience representing clients in government and corporate internal investigations.
Mr. Mancusi counsels diverse clients on corporate issues that relate to banking organizations and structures, including corporate governance, national banking associations, operating subsidiaries, and holding companies under the National Bank Act, the Federal Reserve Act, the Bank Holding Company Act, the Federal Deposit Insurance Act, and the Bank Merger Act. He also has experience with issues related to interstate branching and main office relocations as well as merger-related activities, including bank/thrift combinations, antitrust issues, and affiliate transactions.
In addition, Mr. Mancusi’s experience includes matters related to preparing for, and responding to, examination issues, and compliance with anti-money laundering and foreign assets control requirements. His internal investigations experience involves the Bank Secrecy Act as amended by the USA PATRIOT Act, Office of Foreign Assets Control compliance, the Foreign Corrupt Practices Act, accounting improprieties and misleading financial disclosures, compliance strategy, and civil antitrust issues. Mr. Mancusi has served as an attorney for the Comptroller of the Currency, where he handled federal banking law enforcement actions such as civil money penalties, suspensions and removals, and temporary cease and desist orders.
He currently serves as Chair of the American Bar Association Banking Law Committee’s Enforcement, Director Liability, and Problem Banks Subcommittee. Mr. Mancusi also serves as a member of the Federal Bar Association’s Banking Committee Executive Council. He served as the Chair of the District of Columbia Bar Financial Institution Committee.
About Kilpatrick Stockton
Kilpatrick Stockton LLP is a full-service international law firm with nearly 500 attorneys in nine offices across the globe: Atlanta and Augusta, GA.; Charlotte, Raleigh and Winston-Salem, NC.; New York, NY; Washington, D.C.; Dubai; and Stockholm. Kilpatrick Stockton’s delivery of innovative business solutions provides results-oriented counsel for corporations, from the challenging demands of financial transactions and securities to the disciplines of intellectual property management. Collaboration among Kilpatrick Stockton’s corporate, litigation and intellectual property attorneys provides knowledgeable and proactive guidance for companies at every stage of the business life cycle. For more information, please visit www.kilpatrickstockton.com.
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