Is Citigroup already too big?

By Michael Brush

During the supercharged days of banking before the bottom fell out, Citigroup (C, news, msgs) chief Chuck Prince warned that life for his bank would get "complicated" if the music ever stopped.

"But as long as the music is playing, you've got to get up and dance," Prince quipped in 2007. "We're still dancing."

At the time, Citigroup was racing against megabank rivals such as Bank of America (BAC, news, msgs) to get bigger by issuing more loans, creating riskier debt instruments and gobbling up smaller banks.

That dance is over. Prince has left. And Citigroup's life is very complicated.

Citigroup, like its competitors, has been laid low by debt woes -- multibillion-dollar losses on rotten mortgage-backed securities, rising credit card defaults and, of course, big problems raising capital amid a credit crunch.

Some big banks are using the industry's depressed state to get even bigger, picking up weaker players to boost deposits and balance their bottom lines. Citigroup has tried, and failed, to join in.

A deal could still happen. Reports this week in The Wall Street Journal and elsewhere suggested Citigroup was on the prowl for a target. But the biggest and best targets have already been snapped up.

So here's a better idea, Citigroup: Do shareholders and consumers a favor and buck this trend. You have a poor record of turning deals into profits.

So recognize you're already too big. Split yourself up. Your enviable banking operations, and your brokerage and investment banking divisions, could find good homes and fetch decent prices for shareholders. The card division is more of a challenge, but that could find a buyer as well. Leave the toxic debt in a shell for the government to nurse back to life.

Your other alternative, muddling through while leaning on the government, isn't going to cut it. Your problems are too big.

Missed opportunities

Alas, we shouldn't hold our breaths. Empire-building CEOs rarely go for this option. In this new eat-or-be-eaten banking world, Citigroup wants to be a player.

But so far, Citigroup hasn't kept up with the wave of takeovers driven by the financial meltdown. Bank of America has swallowed up Merrill Lynch (MER, news, msgs) and Countrywide Financial. JPMorgan Chase (JPM, news, msgs) has eaten Bear Stearns and Washington Mutual (WAMUQ, news, msgs).

The time for Citigroup to jump in was in September, when some of the biggest names were really cheap. Citigroup tried to buy Wachovia (WB, news, msgs), but ultimately Wells Fargo (WFC, news, msgs) snatched the prize from its hands.

"Citigroup's competition is getting bigger and stronger and better funded, with relatively stable and lower-cost consumer deposits," says William Isaac, the chairman of the Secura Group, a financial-institutions consulting firm.

Now the credit crisis has eased, and the list of banks to buy cheap has dwindled. The banks large enough to make a difference to a behemoth such as Citigroup are few. They include BB&T (BBT, news, msgs), SunTrust Banks (STI, news, msgs), Fifth Third Bancorp (FITB, news, msgs) and KeyCorp (KEY, news, msgs). Citigroup is the third-largest bank in the country by assets and deposits after JPMorgan Chase and Bank of America, according to SNL Financial, a research firm in Charlottesville, Va.

Stringing together a bunch of smaller banks wouldn't work as well, because the process of turning them all into one organization creates major headaches. Citigroup has struggled with this in the past.

"They are running out of options to make significant acquisitions in the U.S.," Isaac says.

Time to start over?

Without a deal, Citigroup chief Vikram Pandit may be tempted to go back to Plan A, laid out in last year's annual report just after he took over in December: muddle through by shedding nonessential divisions to raise funds and streamline, while relying on billions of dollars of private capital -- since bolstered by a $25 billion government bailout.

This won't be good enough. Citigroup faces overwhelming challenges:

• First, analysts at Gradient Analytics question whether the $25 billion government infusion is enough to shore up Citigroup. Gradient suggests that loan losses will continue to mount, mortgage-backed securities may fetch lower prices than expected, securitized debt may soon have to be brought back on the books, and some accounting maneuvers may worsen debt problems.

• Next, as the economy weakens and unemployment rises, credit card losses will rise well into 2009 and probably exceed historical peaks. This is bad news because credit cards provided 23% of net income at Citigroup in 2006 and brought in more than 100% of net income last year, when mortgage-backed securities losses hit earnings hard.

• Citigroup still has more than $70 billion worth of highly leveraged finance instruments, commercial-real-estate loans, dubious home loans and debt instruments backed by shaky subprime loans. These problematic securities, combined with a troubled loan portfolio, "practically guarantee Citi will not earn its cost of capital for the next two years," Morningstar analyst Jaime Peters says.

• The worst credit deterioration in the third quarter took place in three of Citigroup's most important strategic growth markets -- Mexico, India and Brazil -- notes Glenn Schorr of UBS Investment Research. "Unfortunately, we think it's a trend that continues."

• Citigroup will likely have to raise capital by issuing more stock. That means shares held by current shareholders wouldn't be worth as much. Investors sense this, which puts downward pressure on the stock and makes it harder to use stock to raise funds.

• Meanwhile, the bank still faces integration issues caused by the sheer number of acquisitions over the years. "This is a long-term challenge," says Mark Morgan, an analyst with Thrivent Financial for Lutherans.

"This is no easy fix, even for the best of managers," concludes Susan Roth Katzke, an analyst with Credit Suisse Group (CS, news, msgs).

Continued: Too weak to play

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