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
|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
|New York, New Jersey, and Connecticut||14%||12%|
|Indiana, Ohio, and Michigan||5%||47%|
|Arizona and Nevada||3%||70%|
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.