Friday, March 28, 2014

"The Banks ask for permission.  And the Government says..."

Citigroup ("C" $47.50 per share)

As a result of Dodd-Frank Legislation, our primary bank regulator--the Federal Reserve-- now requires the largest 30 US banks submit to a severe "hypothetical" stress test of their financial condition as a way to measure and determine IF a bank may be overly exposed to risk.  The hurdle relates to their tier one common equity ratio staying above a 5 percent level post-stress.  The 2014 test results were released last week and all but one (Zions Bank) passed.  And while this is good news, the markets yawned.

Now this week:

Step two in the "Dodd-Frank" Regulation (love the name) requires that these same banks submit their annual "capital plans" to the Federal Reserve for comment and approval.   Results were released last night.  And...? Not so good.  Twenty-five of the thirty banks received approval on their submissions but five did not.  The markets tensed, analysts cut ratings and CNBC was able to fill air time on Thursday. 

Let me draw from the Fed's press released dated 3/26/14:

"Based on qualitative concerns, the Federal Reserve objected to the capital plans of Citigroup Inc.; HSBC North America Holdings Inc.; RBS Citizens Financial Group, Inc.; and Santander Holdings USA, Inc. The Federal Reserve objected to the capital plan of Zions Bancorporation because the firm did not meet the minimum, post-stress tier-1 common ratio of 5 percent."

As an owner of Citigroup stock, I was anticipating a pass on this step but was wrong.  And clearly, Citi Management was looking for a pass too. In fact, you can sense surprise by their response alone.  It was weak and went along the lines of "we're being held to the higher standards due to past circumstances."  Management went on to mention their capital plan included substantial share repurchases and an increase in the dividend rate from a penny to five cents per quarter.  This dividend move was one of the core reasons for our move into "C" stock.  News like yesterday was a surprise and is reason to rethink our commitment. 

Perhaps what is most frustrating about this week's news is the fact that their capital plan submission failed to receive Fed permission not because of their current capital position and balance sheet strength, but because the regulators had qualitative concerns.  In other words, Citigroup is having trouble passing the Government's subjective judgments.  A recent operating loss of $500 million in Mexico (fraud) may have been the issue.  My thought: the qualitative issues are likely centered on the company's international segment and is in response to this event. 

But I think I am right about two things on Citigroup:

One, their balance sheet condition is strong today--maybe the strongest in decades.  Two, the valuation on the company is too cheap and investors are demanding much compensation for this risk.  In my eyes, this makes Citi an attractive play at this time. 

Some comparatives (3/27/14)

C : Citigroup Inc NYSE
S&P United States BMI Financials
S&P 500 Index
Price/Forecasted Earnings (FYF)10.4313.4217.20
Price/Tangible Book (MRQ)0.891.042.77
Price/Cash Flow9.106.0814.71
Return on Equity (%)6.746.5713.07
Dividend Yield (%)0.081.911.90

 (source:  Schwab, Thompson Reuters, SP Capital IQ)

For US Banks, there is good news to be found in yesterday's press release from the Fed:

"U.S. firms have substantially increased their capital since the first set of government stress tests in 2009. The aggregate tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, of the 30 bank holding companies in the 2014 CCAR has more than doubled from 5.5 percent in the first quarter of 2009 to 11.6 percent in the fourth quarter of 2013, reflecting an increase in tier 1 common equity of more than $511 billion to $971 billion during the same period.     That trend is expected to continue."


Citigroup needs to mend their relationship with the regulators.  Citigroup will work through the qualitative issues that surfaced in the rejection slip.  Citigroup will likely meet the consensus EPS target of $4.83 per share this year.  Citigroup will continue to build up its capital position. Citigroup will likely be pressured to reorganize.  And once they pass their next capital plan, Citigroup's dividend payout to investors will begin a path to normalization.

I remain a long term buyer.