Citigroup's $100 Billion Problem

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There's no getting around it: Bank stocks look cheap.

With the exception of Wells Fargo (NYSE: WFC  ) , shares in the nation's largest banks are trading for a fraction of book value: JPMorgan Chase (NYSE: JPM  ) at 70%, Citigroup (NYSE: C  ) at 44%, and Bank of America (NYSE: BAC  ) at a pathetic 40%.

As my colleague Matt Koppenheffer recently opined: "Not that long ago, buying any of these major banks at these valuations would have seemed like a no-brainer."

But what looks too good to be true, often is.

While there are many explanations for these valuations -- the European debt crisis, new regulations, and so on -- in Citigroup's case, it has to do with a massive $100 billion portfolio of toxic mortgages sequestered in Citi Holdings, the much-maligned division of Citigroup created in 2009.

How toxic is it?
Allow me to run some numbers by you.

First, at the end of the first quarter, an astounding 31% and 46% of the portfolio's residential first mortgages and home equity loans were underwater, respectively. In Citi's experience, the delinquency rate of these is anywhere between two to four times the delinquency rate of loans that aren't similarly upside down.

Second, $8.5 billion of the portfolio's loans are already delinquent. Of Citi Holdings' residential real estate loans, $3.9 billion is 30 to 89 days delinquent, and $4.6 billion is more than 90 days delinquent.

Source: Citigroup's Q2 2012 quarterly financial data supplement. DPD: days past due. NCL: net credit loss.

Finally, 2.3% of Citi's combined residential first mortgage portfolio is in foreclosure -- because this figure includes mortgages from the Citicorp division as well, it's safe to assume that Citi Holdings' foreclosure inventory alone is proportionally much higher.

For Citigroup overall, in turn, these figures have contributed to quarterly net credit losses of $3.6 billion to $5.1 billion in each of the past five quarters. To give you a comparison, its second-quarter provision for credit losses of $2.8 billion, a related accounting figure, exceeded even its closest competitor in this regard by 55%.


Provision for Credit Losses

Citigroup $2.8 billion
Bank of America $1.8 billion
Wells Fargo $1.6 billion
JPMorgan Chase $0.2 billion

Source: Earnings release financial supplements.

How did it get so bad?
One of the reasons Citi's portfolio of toxic mortgages is so rancid is that a large portion of its mortgages date to 2006 and 2007, when mortgage origination standards were effectively nonexistent.

According to the most recent data I could find, as of a year ago, 37% of Citigroup's U.S. consumer mortgage portfolio consisted of so-called 2006 and 2007 vintages. Notably, these loans have above-average delinquency rates of 6% and 6.8%, respectively.

In addition, many of the mortgages are clustered in states that suffered the largest real estate busts. For instance, 28% of Citi's residential first mortgages are in California, where 39% of its borrowers are underwater, 5% are in Florida with 56% underwater, and 3% are in Arizona and Nevada, with an astounding 70% underwater.


Percent of Citi's Mortgage Portfolio

Percent of Underwater Mortgages

California 28% 39%
New York, New Jersey, and Connecticut 14% 12%
Indiana, Ohio, and Michigan 5% 47%
Florida 5% 56%
Illinois 4% 49%
Arizona and Nevada 3% 70%
Other 41% 23%
Total 100% 31%

Source: Citigroup's Q1 2012 10-Q.

With figures like these, perhaps the question shouldn't be "How did it get so bad?" but rather "Why isn't it worse?" I mean, think about it: Citi Holdings has more than $300 billion in underwater real estate loans on its balance sheet, and it's written off only $3.6 billion to $5.1 billion a quarter!

OK, so why isn't it worse?
The main reason the losses haven't been worse is that the bank has aggressively reduced the size of Citi Holdings over the past few years, pushing the risk onto others through asset sales. At its peak four years ago, the division held $827 billion in assets. Today, it has $191 billion. On average, in turn, Citi has disposed of roughly $40 billion of Citi Holdings' toxic assets a quarter since 2008.

But don't get your hopes up just yet, because in the first quarter of this year, Citi found itself able to sell or modify only about $500 million in delinquent residential first mortgages -- a far cry from $40 billion. In accompanying notes, Citi commented that its "ability to offset increasing delinquencies or net credit losses in its residential first mortgage portfolio … pursuant to asset sales or modifications could be limited going forward given the lack of remaining inventory of loans to sell or modify (or due to lack of market demand for asset sale)."

Thus, from here on out, absorbing losses from the remainder of Citi's toxic mortgage portfolio is likely to be a solo mission.

What all of this means for Citigroup's current and prospective shareholders
To make a long story short, if you follow financial stocks or own shares in Citigroup and have been wondering why the bank trades for less than half of book value, the reason is simple: It's sitting on a $100 billion tinder box of largely toxic mortgages.

Will this cause the bank to fail? No. But will it stifle earnings and prevent the payment of a respectable dividend for years to come? Yes. For how long? Who knows? But I'd certainly say that it's closer to five years than to one.

Consequently, unless you're willing to wait, if you're looking for a suitable bank to invest in, look elsewhere. And one place to start is our recent free report, "The Stocks Only the Smartest Investors Are Buying," which profiles a small bank that has consistently been one of America's best banks, not to mention bank stocks, since the financial crisis.

Access this free report while it's still available.

Fool contributor John Maxfield owns shares in Bank of America. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Citigroup. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (5) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 21, 2012, at 5:40 PM, stockmajor wrote:

    All true, but I don't mind waiting three to five years for an investment that can easily grow threefold or more.

  • Report this Comment On July 21, 2012, at 11:59 PM, neamakri wrote:

    Thanks for a thoughtful and informative article. So banks are choking on their own toxic loans. Good! Hopefully they learn a lesson.

    "pushing the risk onto others through asset sales" ... so who are those idiot buyers? I'd like to know so to avoid them.

  • Report this Comment On July 22, 2012, at 11:47 AM, MAXwolf wrote:

    Neamakri, idiot buyers? Perhaps, all depends on price. I suggest some of those buyers, perhaps the majority, will make excellent returns. Price and time.

    The bank has examiners yelling at them to dump non-performing loans, and rightly so. Forced to sell at whatever they can get because they have to dump regardless of market conditions, they have no time, so very deep discounts result. The buyers on the other hand have time, and if they are playing in the numbers large enough to make a difference, they also have expertise.

    The article suggests that the sales have slowed and they may have trouble converting the balance. I would suggest they have sold the best of the worst, the easiest to get rid of. All of it will sell eventually for something, the question is what.

    We are back to price.

  • Report this Comment On July 22, 2012, at 4:47 PM, WayneGorsek wrote:

    Truly excellent article and one of many reasons I am not buying bank stocks! Thank you for sharing!

    Wayne Gorsek

    Founder, Chairman & CEO

  • Report this Comment On September 25, 2012, at 12:18 PM, 10282018 wrote:

    "Citi Holdings has more than $300 billion in underwater real estate loans on its balance sheet"

    Where did you come up with that number?

    (Q2-2012 assets $191B)

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