Monday was an action packed day for the third largest U.S. bank, Citigroup (NYSE: C ) . The bank announced that it has agreed to pay $7 billion to settle a government investigation into sales of shoddy mortgage-backed securities that helped fuel the financial crisis .
However, this is not it: The company also announced a better than expected quarterly results on the same day.
Focus on future - not the past
First, the settlement is good news for Citi as it removes the litigation overhang and the bank can now concentrate on its core business. It allows the bank to move forward and focus on the future, not the past. The settlement number was also a relief for investors, as Department of Justice (DOJ) was reportedly seeking a fine of $12 billion.
Citigroup is not the first bank to settle with DOJ for its role in the sale of poor quality mortgage-backed securities. JPMorgan earlier paid $13 billion and Bank of America is being pursued for at least $12 billion.
Substantial earnings power
The other good news was the better than expected results. Citi reported adjusted 2Q14 operating EPS of $1.24, beating consensus estimates of $1.05 by 18%. Headline EPS of $0.03 included $3.7 billion mortgage settlement expense as well as a negative CVA/DVA of $33 million.
Citi's results not only reaffirm confidence in the bank's substantial earnings power but are also good news for the other big banks, as trading revenues came in better than expected. The bank is clearly significantly overcapitalized with excess liquidity and this means its earnings capacity is growing significantly.
The bank also continues to make progress on its key strategic priorities of rationalizing its business mix, achieving profitability in Citi Holdings, and fortifying its capital and liquidity position.
Stronger revenues lower expenses
Citi's results were characterized by stronger revenues, lower core expenses, and a lower provision than what the market was expecting. The upside to revenues reflected better net interest income from a combination of asset growth and a lesser degree of margin compression, and stronger trading results than recently reduced expectations, particularly in FICC.
If you take out the $3.8 billion legal charge, Citi's operating expenses reflect the benefits of efficiency gains in the Global Consumer Bank, and lower compensation costs in the Institutional Clients Group from sequentially lower revenues. The lower provision reflected a decline in NCOs, reserve releases in the mortgage and credit card businesses, and the benefits of the transfer of certain loans to held-for-sale.
Resilient trading revenues
Trading revenues have helped boost the fortunes of investment banks but have plunged over the last year or so. Bank's own CFO, John Gerspach, said back in May that trading revenue would fall between 20% and 25%. However, despite fears of a significant drop Citi reported better than expected trading revenues, which only fell by 15%.
This should come as a relief to investors, as a better trading number was needed for the stock to have a near-term catalyst.
Progress on key initiatives
More significantly, the 2Q results demonstrated substantial progress on several of Citi's key strategic initiatives, including the resumption of revenue growth in the Global Consumer Bank and further rationalization in this business' geographies and infrastructure; additional utilization of the DTA; incremental declines in core expenses; continued increases in the company's liquidity position; the achievement of positive net income in Citi Holdings (excluding the settlement charge); and growth in regulatory capital at a magnitude greater than the increases in GAAP capital.
As I mentioned earlier these results should reaffirm confidence in Citi's longer term earnings power and potential to return significant capital. While the Fed's stress test results have pushed out the capital return at Citi, the capital return story remains intact and investors should have confidence in Citi's ability to increase payout overtime.
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