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Summary

  • Citigroup faces a $10B fine from the DOJ for the sale of soured mortgages.
  • Citigroup may be "too big to manage".
  • With flat earnings and recurring lapses in risk management, investors should avoid Citigroup.

Citigroup (NYSE:C) faces a $10 billion fine by the Justice Department to settle a probe over the bank's sale of soured mortgage-backed securities at the height of the financial crisis. According to Bloomberg News, negotiations between the two sides fell apart after Citigroup offered $4 billion to resolve the probe, versus the DOJ's $10 billion asking price. The proposed fine comes after Judge Jed Rakoff rejected a $285 million fraud settlement between Citigroup and the SEC for similar acts amid the crisis:

The SEC accused the company of creating a billion dollar mortgage bond deal - Class V Funding III - to sell off worthless assets to unsuspecting investors; not only did Citigroup market the fund as safe, it took a short position in the assets. Clients who purchased the soured mortgages suffered $600 million in losses. In rejecting the settlement, Rakoff implied that the SEC (1) was looking for a quick headline and (2) had a duty to "see that the truth emerges."

Nonetheless, the U.S. 2nd Circuit Court of Appeals voided Rakoff's decision, citing he had "abused his discretion."

Is Citigroup Too Big To Manage?

Since the repeal of Glass-Steagall banks have been allowed to compete in several financial markets - insurance, commercial banking, investment banking - and in every region. Banks also began betting their own capital; after the federal reserve lowered interest rates in 2001, fixed income instruments became the investment of choice. Banks assuaged regulators and the public that losses amid the financial crisis were an aberration.

However, after JPMorgan Chase's (NYSE:JPM) $6 billion whale trade loss I am not so sure. Earlier this week the New York Times reported that Citigroup may be the victim of commodities fraud emanating from China's Qingdao Port. The fear is that a Chinese company pledged the same collateral for multiple loans. Citigroup and other Western banks have committed billions in the Chinese market for loans backed by commodities. Such losses do not appear to be mere compliance issues, but symptomatic of business models that are too large and complex to properly manage. As a Citigroup shareholder it may not be a matter of "if", but "when" the next shoe is going to drop.

What It Means For Shareholders

People Not Companies Commit Fraud

DOJ head Eric Holder has been embattled for the dearth of white collar prosecutions amid the financial crisis. His policy of only fining banks for wrongdoing ultimately penalizes shareholders and not the individuals who committed the acts. Secondly, by not fining or incarcerating the individuals involved, the DOJ may lose an opportunity to deter future fraudulent acts and protect shareholder capital.

Is Citigroup Worth The Risk?

In Q1 2014 Citigroup earned $3.9 billion on revenue of $20.1 billion. Net income grew 4% over Q1 2013 while revenue growth was flat at (-1%). For premium services such as investment banking, its Q1 2014 fee income of $873 million declined 15% from the same period last year. That said, the proposed $10 billion fine by the DOJ will most likely wipe out the company's full year earnings. At a 13x price-to-earnings ratio, I do not think the stock is worth the risks involved.

Conclusion

The DOJ has reportedly proposed a $10 billion fine for Citigroup's sale of soured mortgages at the height of the financial crisis. With flat earnings and continued lapses in risk management, I advise investors to avoid the stock.

Source: Citigroup Faces A $10B Fine From DOJ