Thursday, April 6, 2017

The Re-Birth of Citigroup

by Roy C. Smith

The Economist recently observed that “Citigroup’s decade of agony is almost over,” and now all it needs to is be able to demonstrate that it can grow again. That will not be so easy. After a decade of focusing on just surviving, it now has to select a business model that can succeed in the decade to come.

Finding successful long-term business models is not something that Citi has been good at. Walter Wriston (CEO of Citibank from 1967- 1984) developed the bank’s widespread international franchise, but he also installed a super-competitive ethos for the bank that led it to great heights before stumbling badly in the 1980s from bad loans and write-offs.  His successor, John Reed (CEO 1984 -1999), led a technology revolution (ATMs, etc.) that installed Citi as the leader in retail banking, but also agreed to sell the bank to Travelers Corp. in a transaction that would establish the surviving enterprise as the world’s largest and most diversified financial conglomerate until that too fell apart.

Reed, who later admitted the merger was a terrible mistake, was eased out by Sandy Weill, Travelers head, who soon launched the aggressive integrated business platform that combined Citi’s lending activities and expertise with Salomon Brothers’ capital markets and trading skills. He also used further mergers to triple the assets of the conglomerate from $700 billion to a peak of $2.4 trillion, and extend its reach, complexity and risk exposures by more than that.

The effort turned out to be a painful lesson in corporate hubris. Citi was deeply tied in with Enron and WorldCom, the two poster children of the tech-wreck of 2000-2002, costing it many more billions in write-offs, fines and legal settlements than it had earned in all of its corporate finance activity since the merger.  Controversies abounded and ultimately Sandy Weill was removed as CEO after the NY Attorney General threatened to sue him and the bank for fraud in 2003.

Sandy was followed by two poorly chosen and ineffective CEOs who were unable to control the reckless, performance-driven juggernaut that Sandy’s ambitions unleashed. There were several further instances of unethical conduct, involving investigations by several foreign governments and a string of US legal encounters that led one federal judge to describe Citigroup as a “serial offender.”

The mortgage securities crisis in 2007-2008, however, proved the undoing of Citi’s voracious business model. It crashed and would have died in 2008, having written off more than 100% of its capital, but the government, fearing the bank was too big to fail, bailed it out – in a series of capital infusions and a lot of assistance from the Federal Reserve.

Since then, the present management team, in place since 2012, has devoted itself to cleaning up the mess. It sold assets, added new capital and did what it could to shore up the balances sheet and relations with its regulators. Total assets are now down to $1.8 trillion and headcount has been reduced from 357,000 at its peak, to 219,000.
But the tougher news is that Citigroup’s stock price, even after benefitting from the Trump rally, is still off 90% from its 2007 peak. And, for the past nine years, Citi’s EVA (return on equity less its cost of equity capital) has averaged -13%; though in 2016, it was only -5.13%. The bank’s price to book value ratio today is 0.80%.

The bank now has two core businesses: global consumer banking and global wholesale and investment banking. Roughly half of the bank’s revenues now come from consumer banking, about half of which comes from Asia, Mexico and other emerging markets.  The other half of the revenues is divided about equally between wholesale banking and securities transactions. Citi’s net income in 2016 was $14.3 billion vs. JPM’s $24.7 billion

In his recent shareholder letter, Citigroup CEO Michael Corbat announced that “our restructuring is over” and that he has a “deep conviction…” that Citi has “the right model, the right strategy, the right customers and clients, and the right people in the right places to meet our update targets.”

These targets include achieving a return on tangible equity of 10% in 2019 after utilizing deferred tax assets. This is a pretty low bar for judging success. (Citi’s ROTE in 2016 was 7.6%; JPM’s was 13%). Return on total equity would be about 2% less than the return on tangible equity.

Nevertheless, Citi’s cost of equity capital (using the Capital Assets Pricing Model) is presently about 12%, which means that even if it hit its target return two-years from now, it still would be earning less than its cost of equity capital more than 10 years after the financial crisis that brought it down.

Corbat is making three key assumptions that will determine the future of the bank.

One is that his choice of a global universal banking business model will pay off despite slow global growth rates and increasing costs and constraints of regulation and exposures to litigation. If the model can only generate a return on equity less than its cost, the long-term prospects can hardly be seen as viable.

Second is that the Citigroup team is capable of executing the business model effectively, despite its broad reach and complexity (e.g. trading operations in 80 countries). Citi has lost some market share in total capital market originations over the last decade, falling to 6th from 4th place. But now that its restructuring is over, will it attempt to catch up by re-adopting the hard-to-control aggressive business practices of the past.

And third, that investors will continue to tolerate low returns and lackluster stock prices (Citi has lagged both JPM and Bank of America over the last ten years, and in the rally since November despite the support of a $10 billion stock buyback program). If these don’t change – and the two-year targets suggest they wont - shareholders may demand yet another management change, one that finally would be willing to break the company up into two separate companies that could operate more entrepreneurially. 

From: eFinancial News, April 1,2017


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