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Summary

  • Argentina’s expected default will be recovered from the pockets of Citigroup and JP Morgan, the CDS writers.
  • If the U.S. court’s ruling is fully enacted upon by the Argentinean government, a series of default will begin.
  • Citigroup failed the stress test of Fed; a red flag for the current and prospective shareholders.
  • Flawed mortgage securities issued in the past continue to teach a lesson to the big banks like Citigroup, Bank of America etc.
  • Risk management continues to be a serious issue for the group and requires urgent attention.

The epitome of a global bank, Citigroup Inc. (NYSE:C), seems to be in a lot of trouble these days as it continues to get hit from every end. Although the bank is consistently working on ameliorating the efficiency of its core operations, the decisions made six to eight years ago continue to haunt the group with the ceaseless repercussions.

Argentina's Default - A Lingering Threat

The Background

A Credit Default Swap "CDS" is similar to an insurance contract where Argentina was assured protection against specific risks associated with default on its national debt by the Citigroup in exchange for credit default spread. In return, the risk "buyer" / long credit i.e. Citigroup agreed to pay the "protection buyer" a pre-determined amount if default occurred. Despite the fact that Argentina had defaulted on a record $95 billion debt in the early 2000s and that Argentina's debt is the world's most expensive to insure, Citigroup decided to take on this extremely high risk opportunity in lieu of the spread that could be earned. The group was focusing on myopic decision making rather than considering the long run impact.

Argentina's Side Of The Story

The U.S. Supreme court has recently given out its decision that requires the government of Argentina to compensate its creditors in full who had not accepted restructured debt back in 2001. This has put additional strain on the Argentinean government which had a scheduled bond interest payment due at the end of June. Moreover, the judgment also blocks any interest payments on restructured debt until these creditors are paid in full.

Presently, an interest payment of $900 million is due on June 30 for bonds issued as part of the debt restructuring undertaken in 2005 and 2010. The court has demanded that Argentina must pay its creditors before it would be permitted to make the interest payments.

On hearing the court's decision, President Cristina Fernandez shared her concern that the country would end up being in $15 billion debt if obligated to repay all holders of defaulted bonds on the same conditions. Consequently, more than 50% of the nation's foreign reserves would be drained.

Default Or No Default For Citigroup

The International Swaps & Derivatives Association (ISDA) is deciding on the matter whether a clause in credit default swaps on Argentina has been triggered after the Argentinean government declared it will default on its bond interest payments.

A U.S. law firm, Schulte Roth & Zabel LLP, expressed its opinion by saying that even if Argentina ultimately made the payment, the government's acknowledged intention to default would trigger the event as per the definitions set forth in ISDA's 2003 credit derivatives section.

However, the uncertainty prevails until the ISDA gives out its final verdict. Staying conservative and assuming the most likely scenario of default, the seller of the swap i.e. Citigroup and JP Morgan (NYSE:JPM) are at high risk to reimburse a significant percentage of the CDS losses which can reach up to $906 million in defaulted bonds.

Dodd-Frank Act Stress Test

In addition to the mounting debt crisis in Argentina, the company was informed by the Federal Reserve officials that the group had failed the stress test. It tested the bank's ability to perform in severely adverse scenarios. Specifically, the bank was unable to pass the red line marked by Fed as it underestimated the risks it faced under a situation of continuous economic stress, and how it would deal with them. In order to pass the test, the bank needs to demonstrate that it can manage such a sprawling organization without presenting systemic risk.

Currently, the bank is subject to some negative covenants until it clears the test. It has been barred from increasing the dividend or announcing additional stock repurchases. The firm had planned to do so in an attempt to please the shareholders. For now, clearing next year's stress test has become the focal point for Citigroup's Chief Executive Officer, Micheal Corbat.

Hit To The Bottom Line

The U.S. Department of Justice has imposed a $10 billion penalty charge for Citigroup's past issuance of defected mortgage securities during the financial contagion. The bank's lawyers are currently looking into the matter.

Another alarming incident took place at Citigroup's Banamex unit in Mexico. Issuance of fake invoices along with loan disbursed to a troubled supplier of Petróleos Mexicanos raised questions about Citigroup's capability to manage the risk of its distant business operations. The fraud has cost the bank a loss of $400 million and effectively, hurt the company's bottom line by $0.13 on a per share basis.

Additional losses due to sheer carelessness can cost big sums to the bank if stringent actions are not taken immediately. After all, they can silently eat away the bank's huge cash balance which can be put to better expansionary use rather than be frittered away like this.

Conclusion

If the current situation persists, then the too big to manage bank may have to be broken down to cater to the size issues and complexities involved. Further, the bank has an ROE of 7.1% as compared to industry average of 9.0%, therefore, I recommend selling the stock.

Source: Citigroup: Has It Become Too Big To Manage?