On Wednesday, the Federal Reserve released its annual Comprehensive Capital Analysis and Review ("CCAR"). This is the second part of the annual stress test where the Federal Reserve either approves or rejects major banks' capital plans (the full report is available here). This year, 30 banks were required to submit plans for approval, and 25 passed while 5 failed. Most notably and surprisingly, Citigroup (NYSE:C) was one of the institutions whose plans was rejected. Even though this is the second time in three years Citi has failed, the market appears shocked, as shares dropped nearly 6% in after-hours trading. Over the past three years, Citi has been systematically cutting risky assets at its Citi Holdings unit and bolstering its capital position. Some analysts expected Citi to hikes its dividend by 400%. When the first part of the test was released last week, Citi was comfortably above the 5% Tier 1 Common ratio at 7.2%, which made a capital return appear to be a near-certainty. Even with its checkered history, this failure was unexpected. Rejection by the Fed is unequivocally bad news as Citi will be unable to return as much capital and takes a hit to its credibility. After going through this report, it seems that Citi is the bank the Fed loves to hate.
The Fed does not release the exact capital return request made by each bank; instead, banks release those details via press releases after the results are announced. Citi issued a release citing disappointment with the results and outlined its plan (release available here). It requested an increase to the quarterly dividend from $0.01 to $0.05 and an increase in the annual buyback authorization from $1.2 billion to $6.4 billion. All told, this would be a capital return of $7 billion. This year, Citi should earn $13.5-$15 billion, so its capital position would actually grow in 2014 by upwards of $8 billion. By rejecting this plan, Citi can only return the same amount of capital as it did last year, a dividend of $0.01 and buyback of $1.2 billion.
Importantly and interestingly, Citi was not failed based on quantitative results. In fact, Citi's performance on the test was quite strong. For capital plans to be eligible for approval, a bank must maintain a 5% Tier 1 Common ratio under the stress scenario and after returning the amount of capital requested. With this plan, Citi still would have a 6.5% ratio under the stress situation, giving it significant breathing room. This ratio was higher than many of the banks that were approved. For instance, Wells Fargo (NYSE:WFC) was 6.1% and JPMorgan Chase (NYSE:JPM) was 5.5%.
Citi passed on the quantitative measure, but it failed for qualitative reasons. In essence, the Fed does not think Citi has enough oversight and control over its business units. Here is the exact rationale for the failure:
"The Federal Reserve's objection to Citigroup's CCAR 2014 capital plan in part reflects significantly heightened supervisory expectations for the largest and most complex BHCs in all aspects of capital planning. While Citigroup has made considerable progress in improving its general risk-management and control practices over the past several years, its 2014 capital plan reflected a number of deficiencies in its capital planning practices, including in some areas that had been previously identified by supervisors as requiring attention, but for which there was not sufficient improvement. Practices with specific deficiencies included Citigroup's ability to project revenue and losses under a stressful scenario for material parts of the firm's global operations, and its ability to develop scenarios for its internal stress testing that adequately reflect and stress its full range of business activities and exposures. Taken in isolation, each of the deficiencies would not have been deemed critical enough to warrant an objection, but, when viewed together, they raise sufficient concerns regarding the overall reliability of Citigroup's capital planning process to warrant an objection to the capital plan and require a resubmission."
Essentially, the Fed believes Citi has further progress to make in understanding the risks of its various global units and projection capabilities during periods of duress. While Citi is clearly better than it was in 2008, the Fed believes more progress can be made. One also gets a sense of frustration from the Federal Reserve, suggesting it has brought up these complaints before and that they have been ignored.
Citi CEO Michael Corbat responded to the failure, saying this:
"Needless to say, we are deeply disappointed by the Fed's decision regarding the additional capital actions we requested. The additional capital actions represented a modest level of capital return and still allowed Citi to exceed the required threshold on a quantitative basis. We will continue to work closely with the Fed to better understand their concerns so that we can bring our capital planning process in line with their expectations and meet their standards on a qualitative basis as well. We have not yet made a decision as to when we will resubmit our plan."
Citi can resubmit a plan, but it will need to show better risk controls; hopefully, it can make specific improvements to satisfy the Fed. Given its sizable capital buffer, Citi most certainly has the capacity to return more to shareholders, and its request for $7 billion was not even that aggressive. It is also important to note that the Fed allowed Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS) to confidentially submit less aggressive capital plans last week when the first part of the test was announced (Bloomberg report available here).
According to Bloomberg, the first request from BAC and GS would have resulted in quantitative failure. To avoid the embarrassment of failure, the Fed allowed both firms to submit more conservative plans and passed them on Wednesday. It is interesting that the Fed provided GS and BAC an opportunity to alter their plans to get approval while no such accommodation seems to have been made for Citigroup. This further suggests that the Fed is frustrated with Citi management and sees more structural control problems.
Of course, this immediately calls to mind the fraud at Citi's Mexican unit, which cost the firm $235 million after tax (details available here). A review of this incident has not turned up any other fraud with the unit. This loss only amounts to $0.08, but as a shareholder, it is certainly frustrating to have $235 million essentially walk out the front door. While the Fed did not cite this incident as a reason for failure, it does feed into the narrative that Citi has a control problem. Given the fact that no other frauds have been discovered, I think this sentiment is overly negative.
As a shareholder, I was disappointed by these results, but continue to believe Citi is a compelling investment. It provides investors with exposure to growth markets around the globe, unlike most U.S. banks. While periods of geopolitical turmoil make a global consumer presence more challenging, I expect long-term growth in Asia, Africa, and Latin America to exceed the growth in developed economies, which will benefit Citi. Management has also been aggressively cutting costs, and net interest margins will benefit from rising interest rates. Citi is also substantially cheaper than peers, trading at a discount to book value.
Book value stands at $65.23 (financial data available here). Including the after-market drop, shares are now only 73% of book value. At the same time, Citi should earn at least $4.75 this year, giving it an attractive 10x multiple. I used this drop to slightly add to my position. The Fed is unhappy with Citi and failed the bank on qualitative reasons, though its quantitative results show financial strength. This will hinder the firm's capital returns and give it another black eye. As a consequence, I do not expect shares to rally substantially in the near term. Investors will also expect more clarity on controls and procedures when the bank announces first quarter results in mid-April.
At only 73% of book value, shares are factoring in all of this negativity. In the near term, I expect Citi to remain range bound between $46 and $50. This failure will likely cap near-term upside. However, Citi is the best financial to own if you want to bet on global growth for the next 5-10 years. This is a fantastic time for long-term investors to buy, not sell Citi. It is best to buy stocks when the bad news is out and shares are below fair value. That is the case for Citi. With an ROE that should approach 7.5-8.1% this year, fair value is at least 90% of book value, or $58-$60. Given the overhang from the Fed, Citi may not be the best trade over the next month, but it will be a lucrative investment over the next several years.
Disclosure: I am long C. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.