Brexit Is Not A Lehman Moment - Citigroup Is Oversold

| About: Citigroup Inc. (C)


This is not a banking crisis - it is a political one.

The financial and inter-bank markets are not currently exhibiting material signs of financial stress.

The large U.S. banks are extraordinarily safe.

Citigroup has declined by almost 10% - one of the worst-performing U.S. bank.

Why is this happening and what should investors do?

Evidently, the smart money was not factoring in a Brexit vote and the "leave" outcome most certainly rattled the markets. Consequently, the (not so) Great British Pound (GBP) dropped to its 1985 low against the USD and the European banks' share price were absolutely decimated (many trading ~ 30% down at the open).

The U.S. banks were also caught in the cross-fire on Friday and were heavily sold-off.

C Price Chart

C Price data by YCharts

The above declines are clearly suggesting a panicked trading session for the U.S. banks - but does it make sense given this is predominantly all happening across the Atlantic?

In this article, I will focus on Citigroup (NYSE:C) - although similar arguments can be made in relation to JP Morgan (NYSE:JPM), Morgan Stanley (NYSE:MS), Bank Of America (NYSE:BAC) and Goldman Sachs (NYSE:GS).

Citigroup is an extra-ordinarily safe bank

I am sure some of the readers (with longer memories) are probably raising an eyebrow or two at the above statement.

However, the fact of the matter is that Citigroup (and the other large U.S. banks) are extra-ordinarily safe. It is not accidental rather by regulatory design and intent. The large U.S. banks should be bastions of calm in the financial markets during stressful times - so far, it seems to be working.

Safety by numbers

All the numbers provided below are extracted from the 1Q'2016 Fixed Income presentation.

Citi has a 12.3% Common Equity Tier 1 (CET1) on a fully phased-in Basel III basis - this translates to $153 billion of the purest form of capital.

Citi also holds $400 billion of High Quality Liquid Assets (HQLA) - these are short term, safe assets that can be readily liquidated in times of stress (e.g. overnight deposits with the Fed).

For context and contrast, Citi total outstanding loans are ~$619 billion (and large proportion of these are very safe assets such as short-term trade finance, Asian mortgages and investment-grade exposures).

These numbers really tell the story by themselves - Citi holds extremely robust buffers beyond any reasonable (or even unreasonable) doubt - and I have not even discussed Total Loss Absorbing Capital (TLAC))

I am certain any bank-skeptics readers would highlight the notional derivatives exposures books (which are denominated in Trillions) - it is beyond the scope of this piece but I did cover this topic extensively in a past article.

Another date point: The Fed's CCAR process

The Dodd-Frank stress tests were released on the 23rd June and Citi's quantitative results were very solid.

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To provide some background on the scenarios assumed in the CCAR stress tests - these are extremely adverse financial scenarios of a deep global recession (think about the 2008/2009 financial crisis or 1930s depression) - i.e. a once in 100 years event or so. Additionally, the stress test assumes a Global Markets shock (GMS) and a default of a major counter-party (in Citi's case, that would most likely be JP Morgan). The models utilized by the Fed and assumptions made (e.g. RWAs increases) in the CCAR test are typically very conservative.

And what is the outcome after stressing for the above scenarios?

For the 2016 test, Citi's minimum CET1 throughout the test period is maintained at comfortable 9.2% ratio (compared with a required minimum of 4.5%).

Safety in numbers - but what about returns?

On a FY2015 basis, Citi has delivered 11% RoTCE (excluding non-productive Deferred Tax Assets (DTA)). This has been achieved in a low interest-rates environment, anemic global growth and headwinds from Energy loan loss provisions.

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Make no mistake about this - these are very credible results achieved in a challenging environment especially when you consider these through a risk-adjusted lens.

The capital return narrative

Clearly, a huge part of the investment thesis in Citigroup is its capital return prospects. Citi currently carries a DTA (mostly relating to U.S. income) of approximately $30 billion. This DTA converts to excess capital over time (depending on utilization) and subject to Fed approval, is available to be returned to shareholders in the form of share buybacks and dividends.

In short, Citi typically generates about ~18-20 billion of excess capital every year that should be returned to shareholders. Given the market cap of the stock is $118 billion - assuming all stays constant, the payback period for an investment in Citi is 6 years!

Final thoughts

Brexit is not a Lehman moment and this is not a financial crisis. Investors should be comforted by the fact that the U.S. banking system is extremely safe.

However, many readers want to understand why Citi sells-off heavily where macro concerns arise - the frank answer is I really don't know. I can only presume a large part of it is driven by algorithms and computerized trading which probably takes into account various generic data points derived on the basis of historic correlations (oil price, yield curve, USD, volatility etc). In my view, it is clearly not driven by the fundamentals of the stock. The trading patterns following the Brexit announcement is probably driven by such models.

It must be very frustrating for Mr. Corbat and management team.

I do believe in time, investors will acknowledge that the firm risk-adjusted returns are extremely attractive and ascribe a more reasonable valuation to the stock. Having said that, the ability to meaningfully pay dividends and execute buybacks is a key prerequisite. This Wednesday, the Fed will release the approval (or otherwise) of the large banks' 2016 capital plans - I expect this to be a good news day for Citigroup.

On a separate but related point, My S.A. colleague JeffA65 attributes the relatively high volatility of the stock to a lack of a meaningful dividend - in his own words:

Recent article in Barron's indicated that in this low rate environment investors are discounting bank TBV as a measure of valuation and focusing more on dividend yield. Investors apparently no longer have confidence in how to value what's on the books of banks (tangible or otherwise). PE doesn't hold as much value either as all the new regulation impairs banks' ability to return it to investors (i.e. trapped earnings). Yes, buybacks are accretive to earnings, but if those earnings aren't actually returned it simply becomes a value trap.

So actual returns (i.e. dividends) have become a more important measure of bank valuation, especially in this yield starved world we live in.

WFC dividend yield = 3.2% and trades at TBV of 1.8
JPM dividend yield = 3.0% and trades at TBV of 1.4
BAC dividend yield = 1.4% and trades at TBV of 0.90

And C?

Dividend yield = 0.5% and trades at TBV of 0.70

I think Jeff is making an excellent point that has not escaped the attention of Citi's management

In my next article on Citi - I will focus on the dividend versus buyback question.

I provide quality and completely independent research on the large U.S., European, Canadian and Asian banks. If interested in CCAR as it applies to the large U.S. banks - do subscribe as a "real-time follower" at the top of this article.

Disclosure: I am/we are long C, BAC.

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.