The Fed Says "No" to Citigroup

The Fed rolled out the second phase of it's "Stress Test" and the big surprise was that this bank was turned down, and MoneyShow's Jim Jubak has an idea why.

On March 26, the Federal Reserve announced its second phase of its stress test. The first phase was looking at banks and saying, "Oh well, if the economy does bad things, if debt does bad things, whose going to have enough capital to get by without really stressing their own financials?" Everybody passed that except for Zions Bancorp out of the 30 banks the Fed tested. The second step, the one that was announced on the 26th, was to look and say, "okay, so these banks all have capital plans, they want to do buy backs, they want to increase dividends. Who's really got the capital to do that?"

The feeling was that maybe the bank that would be most at risk for this was Bank of America (BAC), they didn't pass the first test with a whole lot of margin, but it turns out that the real surprise in this whole list was Citigroup (C). Citigroup, which had done relatively well on the first stage, actually got turned down. The Fed said, "No you can't do the capital plan that you wanted to do"—that Citigroup was talking about spending about $6.4 billion buying back stock and raising its dividend from a penny a quarter to five cents a quarter, and investors were looking forward to that, and the Fed said no.

What's really interesting is that the Fed didn't say no because Citibank's balance sheet—its capital—was too weak. What it said is that it didn't like the way that Citigroup ran its bank, that they were worried that there weren't enough internal controls. They were worried that the bank didn't have a good sense of where its cash was going, that it really couldn't do a good job of quantifying risk. Basically, this is in some ways the worst of two worlds, because in the bad scenario, the Fed comes and says, "Well, you don't have enough capital so that's relatively easy to fix. You go out and raise some more capital, you sell down your balance sheet, you get rid of assets that are making your ratios go down."

That's a relatively simple thing to fix because it's easy to do. The worst scenario, the one that I think that Citigroup has fallen into, is the Fed saying, "Well, you know, you just don't run your bank very well. You've got problems with controls in your Mexican subsidiary. You don't really do your risk well. We don't really trust your capital plan."

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That's a much more difficult thing to turn around because that involves having to restructure the bank, hire new people, set up new rules. All of that has supposed to have been in place over the last two years, and what the Fed is saying is, "Well, Citigroup, you've done a lot of work, but you still have a lot further to go." And that, I think, means that out of all the banks in this list that didn't get their capital plans approved, Citibank, really took the biggest ding.