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Citigroup (NYSE:C), among the worst hit by the financial crisis of 2008, was rescued by the U.S. government with a massive stimulus package. Smarting from the hit, in 2009 Citigroup spun off Citi Holdings, the segment that housed the super bank's bad assets and non-core businesses. Who could have thought then that four years later someone would be talking about Citigroup and bankruptcy in the same breath?

Even as there are visible signs of a turnaround, a former head of Federal Deposit Insurance Corporation (FDIC) has raised serious concerns about the biggest banks in the country and the financial system in general.

Signs of a turnaround

Citigroup's consolidated net income in Q1 2013 was up 30% as compared to the same quarter prior year -$3.80 billion from $2.93 billion.

Total Q1 2013 revenue (net of interest expense) of Citicorp, the consumer banking segment of Citigroup, was $19.59 billion, up 15% from Q4 2012 and 6% from the first quarter prior year. Year-on-year net income was up 17% - from $3.95 billion to $4.60 billion.

Total revenue of Citi Holdings was reported at $901 million ($910 million if credit/debit value adjustments - CVA/DVA - are not taken into account) and a net loss of $794 million. Whereas quarter-on-quarter revenue was down 16%, net loss decreased 24%. Assets of Citi Holdings as of end of Q1 2013 are $149 billion, down from $156 billion in the previous quarter and from $209 billion in Q1 2012.

Increases in revenue and income at Citicorp and positive changes in Citi Holdings' operations are being seen as a sign of a turnaround.

Citi Holdings has to and will be wound down

Citi Holdings' spin-off was at best a piece of financial jugglery and Citigroup is still financially responsible for and bears the brunt of everything that transpires at Citi Holdings.

Assets of Citi Holdings are less than 8% of Citigroup's total assets of $1.94 trillion. Although $149 billion is a whole lot of money, in the bigger scheme of things, it is just small change. Even if the Citi Holdings' spin-off was just an eye wash, it was necessary for diverting the attention of the public and investors. However, finally Citi Holdings has to be wound down for sure but such things cannot be done in a hurry.

Last year in July, a $5.8 billion loss was staring hard at JPMorgan Chase (NYSE: JPM), with a possibility of that figure rising by another $1.7 billion, on account of derivatives trades. It took JPMorgan most of the remaining year to unwind the positions and some of them may still be pending. Read more about what is known as the London Whale here.

So what's the problem?

The problem is not with Citigroup's numbers nor is it that it may take a long time for Citi Holdings to be wound down. The problem is with the financial system that hasn't changed much after the subprime mortgage crisis and the fall of Lehman Brothers. Lessons learned from the financial crisis have not been acted upon as they should have been.

The problem is with the market's perception that banks like Citigroup, JPMorgan Chase and Bank of America (NYSE:BAC) are too big to fail, which they are not if you believe Sheila Bair, former chairwoman of Federal Deposit Insurance Corporation (FDIC).

1. Implied government guarantee

The bailout of the banks has given banks the erroneous impression that the government will clean up the mess, no matter how much of it they make by taking undue risks. JPMorgan's multi-billion dollar trading fiasco is a classic example.

The Frank Dodd legislation bars any future bailout of banks with public money and has some very cogent clauses for sprucing up the financial system. Complex derivatives are to be regulated so that banks do not gamble with their own money. The act also establishes new bodies for monitoring risks in the financial system and for consumer protection.

All that is very good but a major chunk of these rules are still being negotiated and rewritten even after three years since the legislation was passed.

It is not only the banks - even the markets take the government guarantee as a given. This is evident from the cost at which the biggest banks are able to issue debt. According to banking profile data provided by the FDIC, cost of funds for banks with more than $10 billion assets was 26% less as compared to smaller banks with assets below $10 billion and above $1 billion. The average cost of funds for the biggest banks in 2012 was only slightly more than Treasury bills, suggesting that the markets consider the biggest banks relatively as risk-free as the federal government.

2. A Few banks controlling the industry

The legislation has penalty provisions for banks getting too large. For example, Citigroup would have to pay an annual fee of $28 million to be considered "too big to fail."

But on ground, large banks are growing bigger. The big banks are now even bigger than they were in 2007. 1.5% of banks control almost 80% of industry assets; JPMorgan has $2.4 trillion, Bank of America, $2.2 trillion, Citigroup, $1.94 trillion and Wells Fargo (NYSE: WFC) $1.4 trillion.

It is actually a vicious circle. The market puts a higher value to larger banks as compared to their smaller competitors because of the perceived safety. This in turn lowers the cost of money for larger banks as compared to smaller ones. Both factors work as incentives for the bigger banks to grow even more.

Without adequate rules in place, the risk is too big if the system allows such a large chunk of industry assets to concentrate in the hands of 3 or 4 big players.

3. Government may control bankruptcy processes but not the shockwaves

If anyone of them finds themselves in front of a bankruptcy court, the government will take it through the bankruptcy process in a controlled process. The problem is that if that were to happen, as Sheila Bair puts it, the damage, and the shockwaves in the market, this time will be before and not after bankruptcy process.

Conclusion

The problem as I said is not with Citigroup numbers but its growing size. In such a situation, I cannot recommend investing in any of the large banks regardless of the fact that the banking sector is getting healthier and is making good profits.

At the same time, there is a lot of value in the large banks waiting to be unlocked. According to a Bloomberg report, the biggest banks, often called universal banks, are trading at 25 to 30 percent discount to more focused banks that concentrate on trading, investment banking and wealth management. The biggest lending banks are valued lesser than the total value of their pieces taken separately. Citigroup, according to the report, is trading at 14% less than its tangible value.

Sooner or later, the regulators or legislators (failing both, the investors) are going to demand a breakup of the so-called universal banks to downsize them, which is likely to unlock hidden value. I would suggest buying Citigroup only if investors can keep a close watch on the activities of the bank (particularly in complex derivatives) and monitor the negotiation and rewriting of the rules of the Frank Dodd Act.

Source: Is Citigroup Unsustainably Big?