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Citi's Fed Rejection Directly Rebukes Management Team

"They need to take aggressive action to show they're not the old Citigroup."

Posted on March 27, 2014, at 3:30 p.m. ET

A man walks past a Citibank branch in lower Manhattan, N.Y., Oct. 16, 2012.
Carlo Allegri / Reuters / Reuters

A man walks past a Citibank branch in lower Manhattan, N.Y., Oct. 16, 2012.

The stock of the oft-troubled megabank Citigroup is down more than 5% today following news yesterday that the Federal Reserve denied its request to increase its stock buyback to $6.4 billion and increase its quarterly dividend to 5 cents a share from its current $1.2 billion and penny levels.

The reason the rejection is weighing so heavily on its stock is because Citi management has been holding out hope for the increase. Going into the Federal Reserve's stress tests, which evaluate how a bank could withstand an economic crisis on the scale of what happened in 2008, Citi appeared to be well positioned to pass and increase its capital return to shareholders, which lagged well behind its peers like Wells Fargo and JPMorgan Chase.

"It is five years after the financial crisis and Citi still doesn't have its act together," said CLSA analyst Mike Mayo.

Even more damning for Citi's management and relationship with regulators is that on the quantitative aspects of the test, Citi did the best among its peers. The bank really has been prudently building up its capital base, relying less on borrowing to fund its activities and more on retained earnings — which is bolstered by not paying out huge dividends and buybacks — and its equity.

Compared to JPMorgan Chase, Bank of America, and Wells Fargo, the Fed said Citi would have the highest capital ratio in its most extreme scenario for an economic downturn, with a 6.5% tier one common ratio compared to Bank of America's 5.3%, JPMorgan's 5.5%, and Wells Fargo's 6.1%. This ratio measures how much a bank funds itself with equity compared to borrowing, and the results show that Citi would be the healthiest of its peers in another financial crisis.

Citi also had the highest capital ratio, with a Tier 1 common ratio of 12.7% compared to JPMorgan's 10.5%, Bank of America's 11.1%, and Wells Fargo's 10.6%.

Taken together, this makes the Fed's rejection of Citi's rather modest request basically an indictment of its leadership. Mayo said in a note that the Fed's decision was a "shocker" and that Citi should think about breaking itself up and focus on "enhancing governance and holding managers more accountable."

"The Fed's decision makes it look like there is no level of capital that is sufficient whereby Citi could repurchase stock," Mayo wrote. "We believe it is time for management, including the Chairman, to indicate how Citi today will be much better than Citi in the past and take commensurate actions."

Mayo lowered his price target for Citi to $58 from $60 and said in an interview that, "Someone at Citi needs to be held accountable and to me that's the CFO [John Gerspach]."

Citi's new leadership was brought in a year and a half ago with the promise of improving the bank's relationship with regulators. The old regime, lead by former CEO Vikram Pandit and his President and Chief Operating Officer John Havens, was particularly faulted for not getting permission from the Federal Reserve to increase dividends and buybacks in 2012. The Wall Street Journal reported, "Pandit led the board to believe he had a close relationship with regulators" and that the board was "upset over Mr. Pandit's failure to anticipate the Fed's rejection of a plan to buy back shares."

The company's new management has been clear about its need to convince the Fed, with CEO Mike Corbat specifically stressing on its third quarter conference call that it must get the "qualitative" aspect of the capital return process right. "We laid out that we wanted to get the right result in terms of last year's submission. I think we got that and I think importantly, it just wasn't the quantitative piece, it was the qualitative piece," Corbat said.

Nomura analyst Steven Chubak said in a note today that the issues the Fed detailed could be fixed quickly, but that "Citi's relationship with regulators (CEO Corbat was widely perceived to have good rapport with the Fed) may take longer to mend."

In explaining its decision to reject Citi, the Fed said that the bank had "a number of deficiencies in its capital planning practices" and that Citi had difficulties projecting "revenue and losses under a stressful scenario for material parts of the firm's global operations."

One analyst, Gerard Cassidy at RBC Capital Markets, speculated that the Fed's rejection was at least partially tied to Citi's recent massive earnings restatement following its Mexican unit Banamex allegedly getting defrauded out of $400 million by oil services company Oceangrafia, which Corbat described as a "despicable crime." Citi had to restate its 2013 earnings by $235 million as a result. In a research note, Cassidy said, "We believe that the failure was driven from a qualitative perspective with the recent Mexico fraud investigation."

If that's the case, then one of Citi's putative strengths, its business and consumer lending across the world and especially Latin America, might be a weakness in the eyes of its most important regulator, the Federal Reserve. Some 39% of its $76 billion in revenue in 2013 came from overseas and 68% of its $13.7 billion in profits.

This March at an investor conference, Chief Financial Officer John Gerspach said, "Our goal is to increase the amount of capital that we return to shareholders over time," and that the bank's ability to hit its projected 10% return on tangible common equity, a widely watched measure of bank performance, "requires increasing the amount of capital returned to our shareholders in the coming years, subject to regulatory approval."

Those plans are on hold for at least a year, and Citi was only at 8.2% return in 2013. "It's not dead, it's delayed," Mayo said, referring to Citi's increased buyback plans.

Analysts at KBW downgraded Citi to its equivalent of a neutral rating following the Federal Reserve's decision. "We believed that the restructuring would support increased capital return in 2014 (and beyond)," said KBW analysts Frederick Cannon in a note. "However, restructuring has been slow to progress, in our view, and now Citi is faced with the possibility of lower capital return."

But Citi can always up its capital return later — the money hasn't gone anywhere — but Mayo thinks the bank's management needs to make a statement that its forcefully addressing the problems the Fed has identified. "They need to take aggressive action to show they're not the old Citigroup."

Citi's stock has been lagging its peers and its competitor Bank of America — it's down 9% this year.

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