Citigroup Inc. (NYSE:C) passed the stress tests (called the Dodd-Frank Act Stress Tests), but the Federal Reserve rejected capital actions requested that included a common stock repurchase and an increase of the quarterly common stock dividend. There were several factors involved that were influential in the decision, and as the Fed's comment stated, none by themselves were significant, the combination of them brought concerns. The Complete Comprehensive Capital Analysis and Review (CCAR) 2014: Assessment Framework and Results - was published March 26, 2014.
The Federal Reserve approved the capital plans of 25 bank holding companies participating in the Comprehensive Capital Analysis and Review (CCAR). The Federal Reserve objected to the plans of the other five participating firms -- four based on qualitative concerns and one because it did not meet a minimum post-stress capital requirement.
A comparison of the Big Four U.S. money center banks in the CCAR shows that Citigroup has key financial metrics in line with the other three biggest U.S. banks, including some of the highest capital ratios and 2015 financial performance ratios.
The first round of stress tests -- called the Dodd-Frank Act Stress Tests was completed on March 20, with 29 of the 30 banks showing they could remain well-capitalized with Tier 1 common equity ratios of at least 5.0% through a nine-quarter "severely adverse" economic scenario. There was no question that Citigroup, as well as the banking sector as a whole, has greatly improved their financial health. With the 9 quarter test assessment Citi continued to do well. The test was not the issue in the Fed's decision.
According to the CCAR report, the central bank objected to Citigroup's capital plan (dividend increases and share buybacks) based on qualitative concerns. The wording the Fed used was: "significantly heightened supervisory expectations for the largest and most complex Bank Holding Company in all aspects of capital planning."
I want to break this down because here is where we begin to understand what the Fed was concerned with through the process.
Citigroup's dividend proposal was in line with Bank of America (NYSE:BAC) but Citigroup proposed a share buyback plan that was five times greater than what was already allowed and 50% more than what Bank of America submitted in its reduced proposal.
The Federal Reserve also had concerns about Citigroup's ability "to project revenues 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 reflects its full range business activities and exposures."
The one outside piece of information that I believe was inserted from the banking world was the Banamex (Bank of Mexico) fraud factored heavily in the Federal Reserve's decision to reject Citigroup's capital plan. If you review the wording of the Fed's comment you will notice the influence of global operations, its full range of operations and the Fed's assessment of Citi's ability to develop scenarios of internal testing. Here is the paragraph from the CCAR.
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.
Of the three points I highlighted the first is an easy answer, Citigroup Inc., is the largest financial institution in the world, reaching over 200 million clients. This is a positive statement, but also challenges the company to manage controls to a standard beyond what all others in the banking industry perform. Citigroup deals more with the global economy, and over the last quarter has felt the slowdown in the global markets. My second point is strongly tied to the first, the full range of operations provides the largest span of services across all markets that can create more challenges, as well as more opportunities that any of the other large banks, which operate mostly in the United States.
The third point is one I cannot comment on. The Fed's assessment of Citigroup's internal testing. I do not have enough information to compare Citi's internal testing to the other banks, or what the Feds expect. I would acknowledge that Citigroup's testing would be more different, with the focus of a more global market with additional effects that could be driven by regional markets, world politics and conflicts, more than other banks.
Neither Citigroup nor Wall Street expected the bank's capital plan to be rejected. After all, Citi passed the first round of stress tests showing a strong minimum Tier 1 common equity ratio of 7.2% through the Fed's nine-quarter "severely adverse" economic scenario. That was the second-highest ratio among the "big six" U.S. banks, with only Wells Fargo (NYSE:WFC) showing a higher first-round minimum Tier 1 common equity ratio, at 8.2%.
The Way Ahead for Citigroup
Citigroup may or may not appeal the decision by revising their capital actions request. The dividend did not look to be the biggest issue; it was the buybacks. Citi could put a plan in place to better manage its capital planning practices, project its revenue and loss and improve its internal stress testing processes. But this is no guarantee that the Federal Reserve would reconsider.
1. We anticipate Citigroup will continue to make a profit each quarter in 2014. First quarter results should be released around April 15, 2014. We anticipate a quarterly profit between $0.85 and $1.00. With a $3.50 to $4.00 for the year.
2. Citi's book price is listed at $65.08 with the stock trading midday Wednesday at $48.00, which is 73% of book. This in itself is strong consideration to buy for the value of the stock. We would recommend an easy entry point up to $50.00 for the near term, as the stock price is expected to appreciate to near $58.00 by the end of the year. At $58, that would be a 20% appreciation in stock price.
3. As Citigroup continues to buy some of the 3 billion outstanding shares of common stock off the market in the buy backs, this will push (however slightly) the value of the stock upward. If you are a current investor, you could do nothing and enjoy a greater percentage of the profits. In reality, the stock price appreciation will be a greater factor than a nickel dividend per quarter. I hope Citi continues to buy more shares in 2014.
4. The Federal Reserve's current monetary policy of low interest rates has stabilized the housing market and allowed banks to provide a steady flow of business. Citigroup, and the other lending institutions are benefiting from this and will continue throughout 2014.
Our recommendation is to buy and hold Citigroup stock. The stock price appreciation through 2014 looks to have a strong opportunity of double digit growth. The quarterly profits and rising book value are additional positive factors leading into 2015. Now is a great time to grow through Citigroup.
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.