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The Smoke and Mirrors Behind Citi’s Earnings Surprise
10/17/2011 3:45 pm EST
Just shows you should never believe the headlines when it comes to quarterly earnings—especially for banks right now.
According to the headline numbers, third-quarter earnings at Citigroup (C) climbed by 74% to $3.8 billion. The headline number put Citigroup’s earnings per share at a huge $1.23.
So according to the headlines, Citigroup killed this quarter, since Wall Street had been projecting that the bank would earn just 82 cents a share for the period.
Just one tiny problem—the headlines are misleading big time. $1.9 billion of the bank’s $3.8 billion in earnings this quarter are due to a very quirky accounting gain. I say quirky because the $1.9 billion is the result of a decline in the bank’s credit quality.
When a bank’s credit quality declines, accounting rules say the bank should revalue the debt that it owes its creditors. The theory is that debt is now worth less, because the bank’s creditors think there’s a greater chance that the bank will default.
The effect is that as a bank’s credit rating—as expressed in the market for credit-default swaps—drops, the bank gets to record a big accounting gain on its debt. That’s where $1.9 billion in Citigroup’s earnings came from this quarter.
Of course, that $1.9 billion gain is all on paper. The bank has no way to turn it into cash. And if, as Citigroup hopes, the bank improves its credit quality in the future, then Citigroup will have to reverse this quarter’s accounting gain. (By coincidence, JPMorgan Chase (JPM) recorded a $1.9 billion accounting gain for a similar reason when it reported third-quarter earnings last week.)
Without that $1.9 billion, Citigroup’s earnings came in at 84 cents a share. That was a modest two cents a share above Wall Street projections. In the third quarter of 2010, Citigroup showed earnings of 80 cents a share. Second-quarter 2011 earnings were $1.09.
That isn’t to say that Citigroup didn’t make progress in the quarter. Losses from bad loans dropped by 41% in the quarter, due to a decline in defaults on the bank’s credit-card accounts. That let the bank add $1.4 billion back to earnings to reverse the hit to earnings it had taken as it set aside reserves against bad debt.
The bank also continued to sell off troubled assets parked in its bad bank, Citi Holdings. Assets at Citi Holdings fell by 31% from the third quarter of 2010, to $289 billion
But Citigroup’s earnings report basically continued a theme investors saw in JPMorgan Chase’s earnings report last week—banking just isn’t that good a business at the moment.
Loans at the end of the quarter did increase by 13% year-to-year, due mostly to growth in emerging markets. But that wasn’t enough to offset huge declines in other units. Investment banking revenue dropped 21%, as fewer companies did deals, and revenue for market trading activities fell—fixed-income revenue dropped 33% and equity revenue dropped 73%, as trading volumes dropped and as market prices fell.
And finally, Citigroup reported that it continued to reduce its exposure to Greece and the wider euro debt crisis. Total exposure to government and corporate debt in the PIIGS economies (Portugal, Ireland, Italy, Greece, and Spain) ended the quarter at $20.6 billion.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Citigroup as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.
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