Stress Testing Results Make a Compelling Case for Citigroup

Citigroup, one of the largest banks in the U.S., has had a difficult year. Not only did the bank have to deal with the struggles from the coronavirus pandemic, but it also spent a good chunk of the year dealing with regulatory issues related to deficiencies with the bank's internal controls.

While the bank has rebounded in recent months along with the sector, I think Citigroup arguably got some of its best news of the year when the Federal Reserve recently released its second round of stress testing results.

Here's why.

Stock buybacks are once again allowed

In its second round of stress testing results, the Fed determined that because large banks would be well-capitalized in some pretty harsh economic scenarios, they can resume share repurchases in the first quarter of 2021. Most large banks suspended share repurchases early on in the year, and the Fed formally banned them for large banks in the third and fourth quarters of the year.

Image source: Citigroup.

The repurchases will be particularly helpful for Citigroup because there is a very good chance the bank will have the opportunity to repurchase shares below tangible book value. The bank recently traded around $60 per share, and its tangible book value per share at the end of the third quarter was $71.95 per share, meaning the bank currently trades around 83% of tangible book value.

If a bank can buy back shares when the company is trading below tangible book value, it will not only boost earnings per share but also tangible book value per share. If a bank repurchases stock above tangible book value, the bank stills boosts earnings per share but ends up diluting tangible book value.

Stress testing results show Citigroup is in good shape

The Fed's stress testing results showed that Citigroup would sustain significantly fewer losses than its main competitors in the Fed's hypothetical severely adverse scenario. As part of its stress testing, the Federal Reserve puts large banks in the U.S. through certain difficult economic scenarios to see how they would hold up. The goal is to ensure the bank can deal with unexpected loan losses and still have sufficient capital levels to continue to lend to individuals and families during an economic downturn.

In the Fed's "severely adverse scenario," unemployment would rise to 12.5% at the end of 2021 and then drop back down to around 7.5% by the end of the scenario. Gross domestic product (GDP) would decline by about 3% between the third quarter of 2020 and the end of 2021. The scenario also features a sharp slowdown abroad. To put this all in perspective, unemployment in the U.S. at the end of November sat at about 6.7% and GDP at the end of the third quarter had dropped about 3.5% from the end of 2019. Of the big four banks, Citigroup would suffer the smallest amount of losses during the two-year period in the severely adverse scenario.

Source: Federal Reserve.

Citigroup would only lose about $3 billion between now and the third quarter of 2022, much less than the other big U.S. banks. Citigroup in this scenario would be able to generate higher pre-provision net revenue than Bank of America and Wells Fargo, and would also take the lowest provision for loan losses of the four banks, according to the Fed's projections.

Growth and safety make this stock attractive

As mentioned above, Citigroup is trading below tangible book value, and that's largely because of some of the regulatory issues it is dealing with and still needs to address. But the Fed's stress testing results have provided some tailwinds for the stock. First, it looks like Citigroup will be able to repurchase shares below tangible book value in the first quarter of the year. Second, although the Fed's severely adverse scenario is unlikely to happen, it shows that Citigroup would be able to deal with significant loan losses and still be well-capitalized.