Michael Brush

Company Focus11/13/2008 12:01 AM ET

Is Citigroup already too big?

In the new eat-or-be-eaten banking world, Citigroup seems determined to be a player. But with the huge debt problems it faces, it should be selling off instead of acquiring.

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.

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  • 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

Too weak to play

Thrivent's Morgan believes Citigroup may get another chance to buy. He thinks there are enough "land mines" out there -- bad loans yet to be revealed by banks -- that we could see another round of fire-sale stock prices.

But after a year of pounding that has lowered its stock price 65%, Citigroup may be too weak to be a major player. "They don't have the capital to make a big acquisition," believes William Fitzpatrick, an equity analyst with Optique Capital Management. "If Citigroup can right the ship, it might be an acquirer, but not for two years. It is not strong enough now."

Some analysts question whether a takeover strategy even makes sense for Citigroup. "Its rapid growth over the past decade created a hodgepodge of units working separately rather than as one cohesive unit," Morningstar's Peters says. "One may wonder if Citi is too big, too fragmented and too weakly managed to succeed."

I'd say the answer is: Yes, it's too big. The numbers show that Citigroup has a poor record of managing expenses and cutting costs after takeovers -- usually the prime advantages of takeovers. So why do more of them?

Over the past five years, Citigroup's expenses have gone up more than revenue in good times and gone down less than revenue in bad times. This is the opposite of what investors need to see. Consider:

  • Between 2003 and 2006 -- in other words, before the current banking mess hit -- Citigroup's revenue rose by 25%, but operating expenses were up 39%.

  • In 2007, Citigroup's income and earnings were both down 83% from 2006 levels, and revenue fell 9%. But operating expenses increased 18%.

  • In the third quarter of 2008, expenses fell less than revenue and the bank's expense ratio rose 20% more than expected. Citigroup has the second highest expense ratio of all the major banks, according to Morgan Stanley analyst Betsy Graseck.

That tells me Citigroup should stop trying to be a buyer and split up instead. With investment banks entering the commercial-banking world, Citigroup could find many takers. Pandit could start with a call to Lloyd Blankfein at Goldman Sachs Group (GS, news, msgs), whose overtures Citigroup rejected (at least publicly) in late October.

Citigroup, of course, disputes the notion that it faces so many problems that it should split up. The bank says it has adequate capital, because it raised $50 billion before the financial crisis hit hard.

"The company is financially strong and well-positioned for the future," a spokeswoman says. Add in the $25 billion from the government, she says, and Citigroup has a comfortable Tier 1 capital ratio of 10.4%. That is well above the 6% level, where regulators begin to get nervous.

Citigroup also says it might consider buying a bank for its deposit base if the price is right. But it says it doesn't need to, by any means, because it already has a huge deposit base of $780 billion. Plus those deposits come mainly from companies, which makes its deposits more stable than retail banking deposits, if another run on the banks develops, Citigroup says.

The bank also believes it is making good progress selling nonessential divisions and cutting expenses. So far, it has eliminated 12,900 jobs in a planned 22,000 head count reduction that is expected to save $15 billion.

Randy Bateman of Huntington Asset Advisors, which holds Citigroup stock, agrees the bank is on the right path. "Citigroup will come through this looking pretty good," he says. "Citigroup is being castigated because of its diversification, but in reality it is not such a bad thing."

Banks are too big

Whether Citigroup eats or gets eaten, banks are going to get bigger as this financial crisis restructures the whole industry. The trend isn't good for consumers or the country, for three reasons.

Fees go up: Consumers suffer when competition declines because fewer and bigger bigger banks dominate the system. "They have more pricing power," says Thomas Girard, a portfolio manager at New York Life Investment Management. The upshot: Bigger banks will charge more for loans and pay less on deposits, because they can. "I really believe that when you get these one-stop shopping type banks they become inefficient, and it doesn't benefit the consumer in the end," Girard says.

Reserve Bank data confirm that fees have steadily increased as banks consolidated over the past few decades, says Mike Moebs of research firm Moebs Services.

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Credit shrinks: Though it seems counterintuitive, a single, big bank lends less after a merger than the two separate banks lent before a merger, Girard says. That's because the bigger bank cuts back on risk taking, and smaller community banks are better at lending to smaller, local businesses. "They understand them better," says Girard.

Too big to fail: Another problem is that creating megabanks reduces diversification of loan books among banks. Simply put, a small bank in trouble is easier to deal with than a giant whose failure would hurt the whole financial system. "When you have a problem, you have a doozy of a problem," Secura Group's Isaac says.

That's one reason we're in this mess right now. Even bigger banks could mean even bigger bailouts down the road.

At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column.