Citi's International Business Reveals A New Risk

In a delicate process of convincing the Federal Reserve to allow Citigroup Inc. (C) to reward its shareholders, Citi seems to have run into a strategic issue: The risk of its global banking business.

That may make the bank's task to convince the Fed to allow it to return capital to shareholders more complicated than simply retaking the Fed's most recent stress test and asking for less money to be paid out as dividends or used to repurchase shares.

Emerging from the financial meltdown caused in large part by U.S. mortgages, Citi built a strategy around lending, processing payments and issuing and trading securities around the world. "We believe the core strengths and the global footprint of our model are extremely well aligned with global trends and should give us higher growth and opportunities than our domestic-focused peers," Chief Executive Vikram Pandit told investors only last week. "Feel free to applaud."

In the Fed's test, which was imposed on the 19 largest U.S. banks to examine their ability to withstand an economic downturn, Citi's global strategy seemed to add to the bank's risks rather than give it a competitive advantage. In calculating potential losses in a theoretical, severe economic downturn, the Fed put Citi's losses from souring consumer and business loans much higher than potential losses at other banks--including Bank of America Corp. (BAC)--despite Bank of America's struggle with massive losses from U.S. mortgages made by Countrywide Financial, the consumer lender it bought early in the financial crisis.

"We suspect the Fed may have treated foreign loans harsher than domestic ones in its stress test," said analyst John McDonald of Sanford C. Bernstein & Co. Matthew Burnell of Wells Fargo Securities also believes that "in this academic exercise," international consumer loans, in particular, were Citi's main weakness.

The Fed said it doesn't discuss the analysis of individual banks. It disclosed, however, that consumer loan losses were projected partly based on "borrower characteristics, such as credit rating or FICO score." Consumer loans outside the U.S. don't have FICO scores.

But international loans should have less risk, said Sandler O'Neill + Partners analyst Jeffery Harte. Citi makes loans mostly to affluent clients abroad, who default less often, and mortgages outside the U.S. are less risky because banks often can claim more assets than just the house in case of default.

Still, many analysts and even some rival bankers believe Citi asked for too much, given the Fed's apparent risk tolerance. "When we went into this, we said, 'this is a pass-fail test that you can't afford to fail, so you can't get greedy," one executive at another bank said. "The (Fed's) numbers make absolutely no sense to us. I am sure other people felt the same and thought they have a mile of room" in how much they can pay out as dividends or use to buy back shares.

All last year, Pandit was confident that 2012 would be the year Citi would reward shareholders. "We have the capacity to begin returning capital this year," Pandit reiterated last week. Shares of Citi had fallen from about $55 in 2007 to just under $1 in the thrust of the financial crisis, but Citi did a reverse split and is now trading around $35. It had stopped paying a dividend and last year was approved by the Fed to pay a 1 penny dividend.

Several analysts believe Citi asked to return $10 billion to shareholders through share buybacks and a dividend increase--a high amount given Citi's risk-based capital. Given the sensitivity of the test, Citi's actual payout request was likely lower. Sandler's Harte said Citi more likely asked for around $3 billion.

The question now is, how much can investors expect? Citi said it will submit a new test "later this year" and "we plan to engage further with the Federal Reserve to understand their new stress loss models."

Hart said he expects Citi to ask for about $1.5 billion, and Wells Fargo's Burnell said he expects Citi might ask for $2.5 billion. But if the Fed's issue is with Citi's risk profile rather than the amount of money it asked for, some analysts think there might not be any payout this year.

"It feels like the Fed wants Citi to wait," Sanford's McDonald said. "Is it about needing another year to prove itself to the Fed?" Chris Kotowski of Oppenheimer & Co. too believes "it just seems as though this is the Fed's way of saying, 'This is not your year.'"

-By Matthias Rieker, Dow Jones Newswires; 212-416-2471; matthias.rieker@dowjones.com

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