The Dangers of Citigroup’s Litigious Future

Monday was a good day for the stock market, with the Dow Jones Index up nearly 300 points after a disastrous performance last week. The financial sector saw strong gains across the board, as Deutsche Bank‘s (NYSE:DB) stock traded up nearly 9% to go along with a 6% jump in Citigroup’s (NYSE:C) stock. Pre-market trading has seen shares fall back below the $25 mark, with larger losses possible in both the short and long-term both because of broader economic uncertainty and a lack of confidence in Citigroup specifically.

The industry-wide gains in the financial sector are largely due to confidence that European lawmakers are close to a deal that will save the Euro, but similar boosts in confidence have happened throughout 2011, and the long-term reality is that the European market has become increasingly precarious. Greece is still insolvent and Italy’s bond rates are still climbing. For Citigroup, there are much greater worries closer to home.

See Full Analysis for Citigroup Here

The SEC Settlement

The SEC had proposed a $285 million settlement with Citigroup over the bank’s sale of toxic mortgage debt which contributed to the economic downturn of 2008 (See our previous article Citigroup Hopes for Settlement with SEC in Court Today). Such a small amount–about 1.5% of a quarter’s revenue–is close to a rounding error for one of the largest banks in the world. It is no surprise that consumer advocacy groups, Wall Street protesters, and even several investors themselves cried foul. However, Citigroup investors need only worry if the courts themselves agree that such a settlement is unfair.

And now they have.

Yesterday Judge Jed Rakoff, who has openly expressed his distaste for the settlement in prior hearings, has blocked the settlement on the grounds that it is “neither reasonable, nor fair, nor adequate, nor in the public interest,” adding that the SEC is asking him to ignore the public’s interests and the facts of the case itself. “An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous,” he said, adding that this case “touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives.” Rakoff set a trial date for the case to go ahead on July 16, 2012. ^[1]

The Market Fails to React for Now

The news did not affect Citigroup’s share price when it initially hit Monday afternoon, but it cannot ignore what is both horrible PR and a threat of future litigation. This case involves a $1 billion mortgage-linked CDO that the bank sold in 2007 on the eve of the subprime mortgage crisis; the amount is still only 25% of a quarter’s revenue and is relatively little for the banking behemoth. Still, the fact that a comfy SEC settlement cannot pass the courts as readily as it once could suggests that judicial fatigue is setting in. It is also a sign that regulatory settlements cannot be so light in the future. Thus this case is about much more than a billion dollar transaction from four years ago; it is the beginning of a tougher line being taken with the banks.

Just how tough the line will be remains to be seen. When the SEC suggested a $33 million settlement with Bank of America (NYSE:BAC), Rakoff resisted; instead, he approved a $150 million agreement. Rakoff may approve a larger settlement in line with the $550 million SEC settlement that Goldman Sachs (NYSE:GS) paid last year. That settlement did not immediately hit the bank’s stock price, which was around $140 at the time; since then, however, the bank has plummeted to less than $100.

We might see a delayed reaction to the SEC’s failure to pass a cheap settlement with Citigroup. For now, though, investors in the bank should pay more attention to the courts in New York than the bond markets in Europe.

Understand how a company’s products impact its stock price at Trefis

This article was submitted as part of our Trefis Contributors program. Email us at contributors@trefis.com if you’re interested in participating.

1. Citigroup-SEC Mortgage Securities Accord Rejected by Judge, businessweek.com [↩]