Has Citigroup Put the Credit Crisis Behind It?

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I'm here today with Jim Leonard. He's a security analyst for Morningstar. We're going to take a closer look at Citi, and see if any of the firm's bonds look attractive today. Jim, thanks for joining me.

Jim Leonard: Thank you for having me.

Glaser: Let's start with a broad question about the U.S. big banks in general. Can you just talk to me a little bit about how the credit quality of the banks has changed over time?

Leonard: Sure. Obviously, post the credit crisis, all the banks in the U.S. had massive hits in terms of profitability, in terms of balance sheet, in terms of their capital ratios. What you saw is basically, in about 2009, we started to see improvements in those ratios among all the banks, obviously the ones that did not go bankrupt.

So, as we look at the state of the credit world now, about a year and a half from the improvements, we see dramatic improvements in all the ratios, and we see that the credit markets, even though they have improved in terms of their bond pricing, they haven't improved as much as other industrials on a comparable ratings perspective. What we see is that there are several corporations that are a real attractive value for a bond investor.

Glaser: So let's take a close look at Citi then. Has the firm really put the credit crisis behind it? It obviously had a lot of problems, more than even some of its peers. Has Citi gotten its underwriting standards down? Has it really kind of gone off into runoff mode with some of those bad loans?

Leonard: It sure has. One of the key issues for Citi was breaking up the company into two critical parts. One was Citicorp, which is its core operation, which is what you think of more as a core commercial bank. And it put off into another group called Citi Holdings, which was its noncore group and had a lot of the firm's bad assets. And you hate to say it, but it was really, in market slang, the bad bank.

That bank originally was about $800 billion in assets, and today it represents about $300 billion in assets. So, it has been able to work off those bad assets. Meanwhile, it has been able to turn around, and the whole company has returned to profitability. So when we look at Citi, we really feel that a lot of the bad news for the firm has been put behind it, and going forward the firm should be back to its core operating abilities.

Glaser: There is a fair amount of regulatory uncertainty in the marketplace right now. Even after the Dodd-Frank bill, the banks aren't exactly sure what the rules are yet. What impact do you think that will have on Citi bond investors?

Leonard: You're right. There are lot of issues, and exactly how all these smaller issues will play out is still something for Congress and the politicians to sort out. The critical big issue though, with the way we look at it, is that capital is going to be the big issue. And the issue is how much capital is going to be held by each of the banks. What we know is that each of the banks is going to be required to hold more, and the larger institutions such as your Citigroups, such as your Bank of Americas, or your J.P. Morgans, will even be required to hold more.

Now from an equity perspective, you could say well that's going to reduce my return on equity. But from a bond perspective, you really sort of like that because it's more equity underneath you for protection. So from a credit perspective, you should be happy that the government is out there trying to get higher capital requirements.

Glaser: Now you mentioned earlier that the earnings for Citi are starting to come back. How long do you think it's going to take for the company to get back to its core earnings power? To get back to its peak again, if it ever can?

Leonard: I think there are two critical issues. One, is the issue of the U.S. economy as a whole. Now we're seeing a sluggish economy sort of in a growth mode, but not what we consider normal high-growth state. So the first thing that the Citigroup would need to see is a normal economy. Now it's going to be tough for the economy to get back to those levels. Maybe not the 7% unemployment rate, but let's say in a couple of years the levels could probably get back to there.

The other critical issue for Citigroup would be the Citi Holdings assets, when that officially gets drawn down. Our best estimation at this point is that somewhere around 2014 is when those assets will be completely off the balance sheet. It's sort of an estimation that could go quicker with asset sales, and Citicorp is obviously out there looking to try and get some of these assets of the balance sheet. But until those two critical things happen you are not going to see Citi back to its real operating potential. Now the firm still is doing very well, and so as we look at the bonds, it's still a relative value play from a bond investor's perspective.

Glaser: You recently raised your credit rating on Citi. Can you talk to us little bit about that move and why you made it?

Leonard: Sure, basically the largest issue there was that Citi's Tier 1 common ratio went above 11%, and really over the one-year period it raised itself about 200 basis points. So, that really put the firm in line with a lot of the other banks or even greater than a lot of the big banks like your Wells Fargos, your Bank of Americas, or your J.P. Morgans. So we felt that we had rated Citi, given all of its troubles, lower than those other banks, and we really felt that Citigroup had deserved to be put in those ranks. And really when you look at Citi Holdings, as that starts to come down, we really feel comfortable with the job that Vikram Pandit has done, and we feel that going forward the credit is at least or better than its comparables.

Glaser: Finally, do any of the Citi bonds look attractive right now? Are they priced appropriately?

Leonard: Well we think across the curve Citigroup is a relative-value play. It depends on what kind of investor you are. Now if you are an investor that cares about a spread above Treasuries, the credit spread, really the five-year point of the curve looks most attractive. If you're, let's say, just a yield investor, looking for the highest yield you can get for a good rating, you are probably looking at the 10-year sector of the curve for Citigroup.

Glaser: Jim, thanks so much for your insight today.

Leonard: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.