Citigroup, long the problem child of the US banking industry, got a surprise boost on May 06 when it was disclosed government stress tests will require it to raise about $5 billion. The result could strengthen the position of embattled CEO Vikram Pandit, who also surprised investors with better than forecast results last month, although critics warn the bank is far from being out of the woods.
Citigroup's shares rallied 16.6 percent to $3.86 on May 06, because the results on their face seem fairly positive for the bank. Citigroup executives internally view $5 billion as a manageable figure and can easily raise that through measures such as asset sales and exchanging preferred shares.
If the bank can raise somewhere close to $50 billion from exchanging preferred shares into common stock and raises another $5 billion through other measures, it will be left with a ratio of tangible common equity to tangible assets of more than 4 percent, well above all its major peers.
"Ratios like that are something people can get excited about," said Michael Holland, founder of Holland & Co, which oversees more than $4 billion of assets. But whether the government's stress test really does accurately foresee banks' capital needs is difficult to say, particularly if investors do not know the specifics of what regulators credited Citigroup with in assessing its capital needs. For example, the government may have assumed Citigroup will generate some profit in 2009, which would reduce the bank's need to generate capital through other sources.
If Citigroup's trading profits are far below first quarter levels for the rest of the year and its credit losses rise, as some investors forecast, it may struggle to turn in a profit this year.
There may also be items the government did not give the bank credit for, but that most investors would. For example, Citi is selling its Japanese broker and some key investment banking units for $5.9 billion to Sumitomo Mitsui Financial Group. That deal could free up about $2.5 billion of tangible common equity for Citigroup, but it also closes in the fourth quarter, so regulators may not have counted it, analysts said.
When it is all said and done, the stress test results may signal that Citigroup is in good shape for the next few quarters, said Chris Whalen, managing director at Institutional Risk Analytics. But if loan losses keep rising and securitization markets remain sluggish into the fourth quarter, banks broadly may need to raise more capital.
"We have solved this problem temporarily," Whalen added. Determining whether bank loan losses are close to peaking is difficult. A report said pending sales of existing US homes rose in March for a second straight month, a sign that the housing market may be close to stabilising. But unemployment is also climbing fast.
That combined with the high percentage of mortgages exceeding the value of the homes they finance could result in loan losses much worse than banks had expected, analysts.
And government involvement in banks may also limit their profitability. Citigroup could face particular pressure because the United States is expected to hold around 36 percent of the bank's shares.
"The government's lurch to the left and meddling with private capitalism is a real negative and will hurt banks' ability to attract capital," said Charlie Peabody, a veteran bank analyst at independent research firm Portales Partners.
Peabody reckons Citigroup can generate 40 cents a share in profit in 2009 and is generally bullish on the bank sector. These results "take pressure off Pandit," Peabody added. Many investors view Pandit's job as safe as long as he does not need to go back to the government for more capital.