Citi Faces Mounting Tab to Fix Regulatory, Operational Issues

Citigroup's (NYSE: C) better-than-expected quarterly results offered a break from months of bad news, but it will have to be a short one.

A close look at the numbers shows that the bank's fraying relationship with regulators clouds its long-term revenue and earnings prospects.

Citi has uncovered more fraud at a Mexican subsidiary, executives said Monday. And the Federal Reserve's recent rejection of Citi's plan to increase dividends put Chief Executive Michael Corbat and his colleagues on the defensive in conference calls about first-quarter results.

"Let me be clear. Whatever the gaps are between the Fed's expectations and our [Comprehensive Capital Analysis and Review] process, we'll close them," Corbat said on one of the calls. "I'll devote whatever resources and make whatever changes are necessary to accomplish this critical goal."

Yet therein lies the problem.

Citi's regulatory woes and internal control problems show little sign of abating, despite high — and growing — investments in fixing them. Legal and restructuring costs exceeded $1 billion in the first quarter, up 35% from a year earlier.

That's money that could otherwise be spent on the restructuring of its retail network and other projects to jump-start relatively static revenue.

As many as 2,000 employees are working on Citi's stress-testing process, including more than 500 who spend the majority of their time on the issue, Chief Financial Officer John Gerspach told reporters Monday.

Fixing the issue "will require investment in new talent, acceleration of spending on certain systems, and changes to the way we build, validate, and test our scenarios," Corbat said. He acknowledged that the failure of the capital plan meant that Citi would not hit its target of a 10% return on tangible common equity by 2015.

Missing from the conference calls were details about why the Fed rejected Citi's capital plan. The company is in talks with the Fed but has not received formal notice of what was wrong with the plan, Gerspach said. Corbat said that the focus would be on getting approval for its 2015 plan rather than resubmitting the 2014 plan.

Corbat said the company was seeking an "industrial-strength, permanent solution" to the capital-planning problem. Citibank CEO Eugene McQuade this month agreed to delay his retirement to oversee the bank's efforts to get Fed approval.

Citi has now failed the Fed's stress testing twice. The first failure, in 2012, precipitated the departure of former CEO Vikram Pandit and his replacement by Corbat.

"It's disappointing, because part of the reason for bringing Corbat in was the assumption that he would have better relations with regulators than Pandit," said Jeff Harte, an analyst with Sandler O'Neill. "I like that they're taking it seriously and putting the right people in charge, but I had hoped they would have had a better feel by now for what regulators were looking for."

The recently disclosed fraud in a Mexican subsidiary of Citi also cast a bigger shadow. The company disclosed one set of fraudulent loans, totaling about $400 million, in February.

Gerspach told reporters on Monday that the company detected more fraudulent loans to a supplier for the Mexican oil company Pemex.

This second set of loans totals about $30 million, and Citi expects to recoup the money, Gerspach said.

He did not name the company to which the loans had been made.

The two sets of fraudulent loans added $165 million to Citi's first-quarter credit costs, Gerspach said. Those costs could rise; the U.S. Justice Department has begun a criminal probe into why a Citi subsidiary in California failed to file suspicions activity reports about transfers along the Mexican border.

Citi has reviewed its foreign operations and found "nothing, I think, that leads us to have a broader fear, either in Mexico or across the rest of the franchise," Corbat said.

Analysts were hopeful that, following its review of the problem, Citi would be able to minimize the effect of the fraud.

"The scale of the loss is very manageable for Citi," Harte said. "When you span the globe like them and span the financial services like them, it's very hard to avoid having these kind of issues."

Still, Citigroup offered  investors some good news. First-quarter profit of $3.9 billion beat most analysts’ estimates, and Citi's stock rose more than 4% Monday, to $47.67.

The largest factor contributing to Citi's positive results was a decline in losses at Citi Holdings, a division created during to financial crisis to house unwanted assets. Losses in that unit, which consists mostly of North American mortgages, fell by about $520 million, to $284 million.

Cost cuts were another factor. The company shaved about $260 million in quarterly expenses compared with the first quarter of 2013, Gerspach said. It plans to reduce its headcount in its global consumer-banking business by about 4,000 by yearend and shut about 75 more branches, it said in a slideshow presented to investors. News reports on Monday said the company also plans to cut 300 jobs in its trading division.

"Citi has been at the process of rationalizing its cost structure under its new CEO for a little more than a year, and I think we're starting to see some tangible results," said David Hilder, an analyst at Drexel Hamilton.

In an echo of JPMorgan Chase's first-quarter results, however, Citi saw declines in revenue from bond trading, mortgages and investment banking. Overall, Citi's adjusted revenue fell 2%, to $20.1 billion. Its retail banking revenue fell 28%, to $1.1 billion.

But these revenue declines weren't as bad as many analysts had forecast; trading revenue, for example, fell 13%, while analysts had pegged the decline in the high teens. Gerspach expects bond-trading revenue to fall by about 5% to 10% on the year.