Let's not talk around the subject: Short-term headwinds persist for Citigroup (NYSE:C) with respect to a potential settlement with the Department of Justice.
While the bank is still clawing its way back to normalizing bank profits, legal troubles continue to be an ongoing headache at one of the largest banks in the country.
However, legal troubles and settlement risk are only likely to affect Citigroup's share price in the short-term, while the long-term earnings power of Citigroup will remain unaffected.
Department of Justice playing hardball
Just like Bank of America (NYSE:BAC), Citigroup was one of the financial institutions that really pushed mortgage originations and were big players in the mortgage-backed securities (MBS) business before the financial crisis erupted.
Unfortunately, as it turned out later, underwriting standards were so diluted that the bank took serious hits to its bottom line as delinquencies soared and the values of residential MBS collapsed.
As a result, the Department of Justice has started to probe the banks' mortgage selling practices, which contributed materially to the implosion of the U.S. housing market, and is currently in settlement negotiations with Citigroup and Bank of America.
While Citigroup offered to put approximately $4 billion on the table to resolve the probe, Bank of America offered $12 billion to settle with the Department of Justice.
Bank of America's settlement offer is larger than Citigroup's offer due to Bank of America's larger origination market share.
In any case, those are serious dollars and settlements certainly have the potential to cause some short-term damage to the share prices of the two banks.
However, the Department of Justice and lead investigator and negotiator Associate Attorney General Tony West would have none of it.
The DOJ, driven by an increasing desire to raise its public profile as a tough prosecutor of banks that engaged in mortgage misdeeds, actually demanded Bank of America to pay up as much as $17 billion while Citigroup was said to have to pay $10 billion in order to end the DOJ's probes.
Associate Attorney General Tony West's approach to dealing with Bank of America and Citigroup and his unwillingness to settle for the offering amounts, are certainly indicating a tougher stance on the banks, that could define the way authorities deal with financial institutions going forward.
Just last week it was reported that Citigroup is now nearing a deal with prosecutors to resolve the mortgage probes for a consideration of $7 billion.
Settlement good for Citigroup and shareholders
Generally speaking, a $7 billion settlement with the DOJ is good for Citigroup, because the bank avoids the maximum settlement of $10 billion or a long, costly court battle with the DOJ which clearly would be a public relations disaster.
A settlement is also good for shareholders as a lot of uncertainty hanging over Citigroup's stock is going to subside.
By extension, it is also a good development for Bank of America which surely is closely watching the negotiation progress between the DOJ and Citigroup, because of its implications for its own negotiations: A $7 billion Citigroup/DOJ settlement would certainly suggest, that Bank of America will be able to settle for a considerably lower amount than the $17 billion that is currently being circulated.
Both Citigroup and Bank of America are still trading cheaply with both banks displaying serious book value discounts of 29% and 26% respectively.
Though settlements, if finalized, might cause some short-term selling pressure, the value proposition of Citigroup and Bank of America will only become more compelling as the long-term earnings outlook of the two banks will not be affected by the settlement at all.
The Foolish Bottom Line
Investors, who are invested in Citigroup for the long haul shouldn't sweat the settlement at all. Based on conventional book value metrics, Citigroup is already cheap.
Should investors sell off Citigroup in light of an announced settlement with the DOJ, this would make for an extraordinary purchase opportunity for an already cheap large-cap banking franchise.