Citigroup’s Rumored $7 Billion Mortgage Settlement Could Send Q2 Results In The Red

The second quarter of the year has been an eventful one for Citigroup (NYSE:C), with the bank successfully disposing of its retail banking operations in Greece and Spain as a part of its continued efforts to shrink the Citi Holdings division (see Citigroup Inks Deals To Dispose Of Retail Units In Greece and Spain). But going by recent reports, the bank looks keen to accompany its Q2 earnings release on Monday, July 14 with the much-awaited news of its mortgage-related settlement with U.S. regulators. ^[1] Picking up settlement talks after they broke down last month when Citigroup quoted the “low” figure of $3 billion, the globally diversified banking group seems to have successfully put a lid on the contentious issue by agreeing to pay $7 billion. That’s well above the $3 billion in reserves the bank had set aside for this purpose, and as a result we will likely see the bank taking a pre-tax charge of $4 billion in Q2 to cover the payment.

This, combined with the bank’s announcement in May that Q2 trading revenues are expected be 20-25% lower than the figures reported a year ago, indicate a possible quarterly loss for Citigroup this time around. ^[2] The bank reported net income of $4.2 billion in Q2 2013, on revenues of $20.5 billion, and if we assume that each of the bank’s operating divisions – except for the trading desk – fared as well this quarter as they did a year ago, then the trading hit would send revenues to below $19 billion, while the settlement charges will wipe out profits entirely. Notably, JPMorgan Chase (NYSE:JPM) ended up with a similar quarterly loss in Q3 2013 after settling its mortgage-related issues for a whopping $13 billion.

We have a $53 price estimate for Citigroup’s stock, which is roughly 15% ahead of the current market price.

See our full analysis for Citigroup

Depressed Trading Activity To Drag Down Revenues For The Fourth Consecutive Quarter

Investor expectations for trading desks at the world’s biggest banks were set in May, when both JPMorgan and Citigroup raised warnings about a fall in trading revenues for the second quarter. ^[3] While JPMorgan expected a 20% fall in markets revenue year-on-year, Citigroup estimated a sharper 25% decline. The importance of trading to Citigroup’s operating results can be understood by the fact that these operations contribute roughly 20-25% of the bank’s total revenues and as much as 40% of total earnings in any given period. This is why Sales and Trading figures as the most valuable business segment in our analysis for the bank as shown in the chart above – making up almost one-third of its total share value, according to our estimates.

Citigroup generated revenues of $4.3 billion through its trading operations (fixed-income and equities taken together, adjusted for CVA/DVA) for the second quarter of last year and $4.7 billion in Q1 2014. If the bank’s trading revenues actually tanked 25% in Q2 2014 compared to Q2 2013, then we are looking at a figure of around $3.2 billion for the quarter – a 32% drop from the seasonally boosted performance in the first quarter. As we have pointed out on several occasions in the past, Citigroup leans more heavily on its debt trading compared to equities trading to make money – with the former often contributing 80% of its total trading revenues. This explains the hit to revenues for the quarter, which saw sub-par levels of debt trading activity across the globe.

Citi Holdings Could Report First Ever Quarterly Profit In Q2

Citigroup’s Citi Holdings division, often termed the “bad bank,” was created in 2009 to house all the poor-performing and non-core assets that the group sought to dispose of over time. Since then, the bank has made significant progress managing this division, as it cut down total assets from roughly $900 billion at the peak of the economic crisis (more than 40% of Citigroup’s total asset size) to $114 billion by the end of Q1 2014 (around 6% of total assets). In the process, the Citi Holdings division has incurred significant quarterly losses over the years.

However, losses for the division have steadily declined over the last few quarters, with the figure for Q1 2014 being $283 million. With Citigroup successfully getting rid of its loss-prone retail banking operations in Greece and Spain this quarter, we expect the total assets to shrink to below $100 billion even as the division as a whole reports its first net profit figure since it was created. This should be a big plus in Citigroup’s performance for the quarter, which is largely expected to be lackluster.

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1. Citigroup Nears Deal to Resolve Mortgage Probe, The Wall Street Journal, Jul 8 2014 [↩]
2. Citigroup Trading Revenue Will Likely Drop Further, CFO Says, The Wall Street Journal, May 27 2014 [↩]
3. ref:3 [↩]