Citigroup Is In Trouble Again

| About: Citigroup Inc. (C)
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The NYT is reporting Citigroup may be the victim of another fraud.

What is the financial impact?

What is the larger impact in the context of other recent events?

By now, we're all familiar with Citigroup's (NYSE:C) unpleasant issues with the fraud investigation at its Banamex unit. The loans that were based upon fraudulent collateral were apparently worth around $400 million in that instance. I've seen reports where Citi is going after some of the money it lost, but to be honest, I'd be surprised if the bank can recover anything at all. Dealing with that and the embarrassment of the CCAR failure has left management reeling. Either one of these issues is big enough on its own, but now, we've got another potential issue, and it's not looking good.

The New York Times is reporting Citi may now be the victim of fraud in China as well. The potential fraud centers around a scheme in which a borrower parks metals, like copper, at a port, and then takes on debt that is collateralized by the metals sitting in the port. The borrower then uses the money to speculate, and later, sells the positions it has amassed with the money or the metal itself, in order to pay off the debt. This only works, however, if the borrower takes on only the amount of debt it can collateralize. The NYT's assertion is that Citi's borrower, Mercuria Group, may have taken on more debt than it can properly collateralize by pledging the same metal for multiple loans.

The potential exposure is up to $160 million for Citigroup, according to the report, and while that is a lot of money for sure, Citi can absorb that without issue. I'm not worried about the $160 million; I'm worried that Citi has no control over its global operations. The Banamex fraud showed a disturbing lack of checks and balances in lending enormous sums of money based on fictitious collateral, and it looks like we may have the same issue here.

If it turns out that Citi did lend money to yet another client to the tune of hundreds of millions of dollars without bothering to verify the existence of collateral, I may consider selling my position in Citi. The bigger implication beyond simply the prospect of losing $160 million is that Citi may, in fact, be too big to manage. I applaud the way Citi handled the Banamex fraud, and while it is still ongoing, I think some good will come of it. But seeing yet another potential fraud of virtually the same type makes me think Citi doesn't know what it's doing. I'm okay with the Banamex fraud being a freak event that Citi is a victim of, but if this is happening in other places, Citi is to blame for being so negligent.

I believe very strongly in the earnings power of Citigroup. I think we'll see Citi earning $6 to $7 in the next couple of years, and as a result, I think shares will trade in the $70 range in that time frame. However, these frauds are a major black eye for Citi management, as it is dealing with a much bigger deal already; the CCAR failure. The earnings impact of the Banamex and China frauds are pretty minimal given how much money Citi makes every year, but the bigger implications make investors pause. How can we trust earnings projections and even book value when we don't know that Citi knows how to make a collateralized loan? That sounds hyperbolic, but it's the simple fact of recent events.

I am not selling yet, because I still think Citi is the cheapest bank out there. However, earnings projections and cheap valuations are only as good as investors' faith in the business. If Citi can't make collateralized loans without being subjected to enormous fraud, it is in a lot of trouble. These frauds just make people think there are more that we don't know about yet, and eventually, investors will lose faith in management, as I know some already have. I'm not there yet, but there's only so much I can take. I want to own Citi because I think the upside is still pretty huge, but I am embarrassed for management with these fraud reports.

Disclosure: The author is long C. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.