Citigroup (C 5.22%) CFO Mark Mason recently spoke at the Goldman Sachs Financial Services Conference and mentioned at the very end of his Q&A that the bank would be pausing share repurchases in the fourth quarter. That buried comment caught plenty of shareholders off guard, including me.
Part of the thesis for owning Citigroup right now is that the bank can repurchase a lot of shares while the stock is trading below tangible book value (TBV), which is what a bank would be worth if it were liquidated. When a bank repurchases shares below TBV, the math works out so that TBV grows and bank stocks typically trade relative to their TBV, so a growing TBV is very good for the stock long term.
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Having the ability to repurchase shares below TBV is rare, so it excited investors such as myself that Citigroup would be able to take advantage of this while cleaning up all the other issues at the bank and planning a new path forward. Let's take a look at why the bank had to unexpectedly pause share repurchases and what it means for Citigroup stock moving forward.
Citigroup needs to account for SA-CCR
Banks are complex companies and have many rules regarding how much capital they must hold in reserve for all of their operations that could result in losses (loans, for example). At the start of next year, another complex regulatory rule will go into effect, which is being referred to as the standardized approach for measuring counterparty credit risk (SA-CCR). To make a long story short, SA-CCR will require large banks like Citigroup to change the way they calculate their risk as it relates to derivatives contracts.
As you may recall, derivatives, which are financial instruments such as mortgage-backed securities, played a role in the Great Recession. The overall result of SA-CCR is that most of the large banks will see an increase in their risk-weighted assets (RWA). Banks hold regulatory capital based on their accumulated RWA, so if their internal regulatory capital ratio is 10% or 11% and then RWA increases, they now must hold more regulatory capital to maintain that ratio. And the more regulatory capital a bank holds in reserve, the less it has for investing back into the business or making capital distributions like dividends and buying back stock.
At the conference, Mason said SA-CCR is going to lead to an increase in RWA of $60 billion to $65 billion, which could require Citigroup to add an additional 0.50% to 0.60% of regulatory capital. That's not an insignificant amount. It's curious, though, that I haven't heard about any other large banks pausing share repurchases due to SA-CCR, despite having to increase RWA.
This might have happened specifically to Citigroup because the bank has begun a strategy refresh with a lot of moving pieces. For instance, the bank is exiting 13 global consumer banking franchises as part of the broader plan to wind down areas where it doesn't have the scale to compete and instead invest in higher-return businesses at the bank. In the fourth quarter, Citigroup announced that it would be winding down its consumer banking franchise in South Korea, which may result in a charge as high as $1.5 billion. In the third quarter, Citigroup took a $680 million pre-tax loss related to the sale of its Australian consumer banking operations.
Mason said Q4 would be a bit of an "anomaly" when it comes to the bank's capital return philosophy and share repurchases, specifically citing SA-CCR and the Korea charge. With SA-CCR requiring higher RWAs and the Korea charge eating into earnings this quarter, the bank may have run out of room above its target regulatory capital ratio to be able to do the share repurchases it had initially planned.
What now?
The paused share repurchases are disappointing, not only because I had just recently purchased call options after Citigroup's pull back into the low $60s, but also because it looks like management either didn't do a great job of capital planning or didn't effectively communicate this with shareholders. Mason said the bank will resume repurchases next quarter at a level similar to that of Q3, which I think also came up a little short of investor expectations in terms of how much Citigroup bought back.
With Citigroup trading at this beaten-down share price and now far below TBV, the bank should be repurchasing as many shares as possible. With the poor track record that Citigroup has had over the years, management really can't afford to be making mistakes like this because shareholders are pretty fed up at this point.
I still believe in the refresh strategy and Citigroup's story, however. But this is mostly because a bank with the U.S. deposit market share that Citigroup has acquired and its successful investment banking unit should not be trading this far below tangible book value.
