Early Monday morning, both Citigroup (C) and the Department of Justice confirmed that the bank would pay $7 billion in a settlement for its part in the residential mortgage-backed securities blowup that caused the worldwide global financial crisis in 2008.
While the ethics of the settlement relative to the size of the crisis can be debated, investors care much more about what this means for Citigroup’s future earnings potential. Citigroup also announced earnings this morning, but before that the stock jumped about 1% higher before their release. After the release, the stock rose higher, and traded about 3% higher than the previous day for most of Monday.
The news was unexpected, but still not fully priced in, as the options market demonstrates. At-the-money weekly calls were trading at around 64 cents before the news, but jumped 90 cents by mid-day, meaning the market had mispriced the market’s reaction to Citigroup’s earnings announcement—and had not priced in the settlement announcement at all. Options traders more than doubled their money with these ATM options.
The settlement means that C will have to pay a large amount of money, which sounds bad at first glance. Upon closer scrutiny, the jump in the stock makes sense. Knowing what the settlement will be removes uncertainty, and thus risk, to the stock, making it more desirable.
Additionally, since C earned about $3.8b this quarter, the fine represents about 3 quarters of earnings—a large debt to be sure, but not insurmountable. As of the end of the first quarter of this year, C had net assets of $210 billion, meaning this settlement represents 4.3% of the bank’s total equity. Also significantly, C is still trading at a discount to book value (price/book remains at about .7, as it has for most of 2013 and 2014).
While the settlement surprised the market, the company’s earnings provided more upside. The bank’s EPS of $1.24 for the quarter (adjusted for the settlement) beat expectations by 19 cents, while revenue down year-over-year by 3.2% to $19.37b was also a modest surprise. Much more importantly, C has seen the cost of credit fall 15% year-over-year and operating expenses have fallen 3% year-over-year.
While this is good news for shareholders, bears on the stock still have a lot of ammunition. Revenues are down, meaning either C’s market is shrinking or its marketshare is shrinking—neither is a good sign. C also saw steep declines in many of its business practices; mortgage originations fell 64% year-over-year and consumer banking revenue fell 3.5% year-over-year. Likewise, the bank saw its fixed income revenue fall 12% year-over-year while trading revenue fell 15%. In other words, Citigroup is getting smaller.
Going forward, bulls and bears will need to project how C’s return on equity will trend given these results. On the one hand, less transactions means C is going to get smaller over time, but if the bank can continue to cut costs to allow ROE to grow or at least remain steady, the bank can continue to provide value for shareholders. The shrinking business is already priced into the stock, since its price-to-book is below 1 and its P/E ratio is 11.4, well below the S&P or even financial sector averages. Now bulls and bears will need to calculate whether the market is mispricing the bank’s decline by making it too cheap or too expensive.