Holding Out for a Bank Hero

Surprisingly, the fed rejected this bank's capital plan, and MoneyShow's Jim Jubak thinks that, in order to move past this hurdle and turn things around, the bank needs to admit culpability and be willing to change.

Ouch! On March 26, the Federal Reserve rejected Citigroup's (C) capital plan.

No dividend increase from a penny a quarter to 5 cents a share, as the bank had planned. No $6.4 billion stock buyback as Wall Street had calculated.

Investors were not amused. Shares of Citigroup fell to $47.75 on March 27 from $50.30 on March 25. That's a 5% drop.

The buy/sell/hold decision now rests on how serious you think the problems are that the Fed flagged. (Citigroup is a member of my Jubak's Picks portfolio.)

The Fed's rejection of the bank's capital plan came as a surprise to the market (and to me). Citigroup had passed Round one of the Fed's stress test of 30 big US banking operations. The bank's 6.5% Tier 1 capital ratio under the stress test scenario was, after all, above the Fed's 5% minimum.

So, Citigroup should have been allowed to go ahead with its capital plan, no?

Well, no.

The Fed rejected the bank's plan, not because Citigroup didn't have adequate capital under the conditions of the Fed's test, but because the Fed had serious reservations about the quality of the bank's ability to estimate revenue and the accuracy of the loss projections that the bank calculated for the stress test. The Fed particularly cited problems with projections in "material parts of the firm's global operations."

In other words, the Fed didn't object to the quantity of the bank's capital, but to the quality of the bank's management of its business.

The difference is huge for shareholders. It's relatively easy to fix a capital ratio problem. You sell off some assets to reduce the capital you need (and to raise the ratio), and you can also raise some capital in the markets. The path is very well explored. A bank doesn't need to invent anything from scratch.

Meeting the Fed's challenge to improve management isn't nearly as easy. Remember that the current CEO at Citigroup, Michael Corbat, took over in 2012, when investors lost patience with the pace of efforts to restructure the bank under then-CEO Vikram Pandit. And remember that the Fed's criticism comes hard on the heels of an investigation into a $400 million fraud involving Citigroup's Mexican unit, Banamex. The New York Times has also reported that federal prosecutors are looking into internal controls at Citigroup's international payment business. The worry is that the bank's internal controls aren't sufficiently tight to prevent money laundering.

All this has led for calls for change, as limited as replacing the bank's current chief financial officer, to as major as breaking up the bank as "too big to manage."

So far—and it's been only a couple of days, I grant you—I haven't found CEO Corbat's response to the Fed's veto to be particularly encouraging to me as a shareholder. The bank's initial response—and it's in keeping with the response to the Fed's stress test for big US banks in general—has been to blame the Fed and fault the process. A quote in the Financial Times from an unnamed Citigroup executive sums up this attitude: "Every year the Fed has to pick on someone and this year it was us—it seems, because of our global complexity."

Yeah, like there aren't real problems with that "global complexity."

I think it's pretty clear that if it comes down to a contest between the Fed and Citigroup, that Citigroup will be the loser—especially since the bank begins any contest with that Banamex fraud case hanging around its neck.

Will Citigroup move past this "poor me" response to change its structure and organization in ways that let the bank prove that it's not too big to manage and that it's not a grab bag of businesses put together by former CEOs? The bank has under-invested in businesses, such as its credit card unit in recent years, as it fought its way out of it's post-global fiscal crisis hole. That's the big promise in Citigroup's future, but to get there, the bank has to admit its current structural problems (and they're not limited to those flagged by the Fed).

I'd like to see Corbat lay out a plan for doing that. I'm willing to give him some time to do that. But not forever. Until I hear that from the bank's CEO, I'd call this a hold.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Citigroup as of the end of December. For a full list of the stocks in the fund see the fund's portfolio here.