Highlights From Citi's Q3 Conference Call: Accounting Gain Raising Profit; Comments on European Exposure

Citigroup, Inc. (NYSE: C) reported Q3 EPS of $1.23, which may not compare to the analyst estimate of $0.82. Revenue for the quarter came in at $20.8 billion versus the consensus estimate of $19.59 billion. The bank said earnings excluding credit valuation adjustment totaled $0.84.

Highlights From C's Q3 Conference Call:

• (Vikram S. Pandit, Chief Executive Officer) Earlier today we announced net income of $3.8 billion or $1.23 per share for the third quarter. When you exclude CVA and focus on our operating results, we earned $2.6 billion or $0.84 per share. These are solid results particularly in a macroenvironment in which economic and political uncertainty created a lot of market volatility.
  
• I believe that Citi's performance during this quarter shows the significant progress we have made in improving our risk management, one of my top priorities when I became CEO. We've completely revamped our risk profile, risk approach, and most importantly, our risk culture. We've put in place robust practices in the businesses and regions to integrate risk analysis into decision-making.
  
• Today, you have another example of this improved risk management in the update on our European exposure. More than 18 months ago, we recognized a potential for Greece's sovereign debt issues to impact other countries in the euro zone. Since then, we have reduced our exposures where needed, while continuing to serve our clients diligently.
  
• In terms of funded exposures, we have net lending exposures to the GIIPS sovereign entities of $1.5 billion and we currently don't have any France and Belgium net sovereign lending exposure. Our GIIPS financial institution net lending exposure is $2.1 billion, and our France and Belgium financial institution net lending exposure is $2.3 billion. Our exposures include lending to foreign subsidiaries where applicable.
  
• Margin may be held against some exposures, reducing our net exposure, while other exposures are collateralized. We are providing that margin and collateral information as well.
  
• Lastly, our exposures to corporates are partly driven by global banking and a large amount of these exposures are to large multinationals that participate in global trade and capital flows.
  
• Our credit portfolio in the emerging markets is diversified by country and by product. The credit quality in these portfolios is not only good, in fact, in most of the countries where we do business, it's even better than the U.S. And the credit margins we earn in these markets are substantially better than the margins the industry earns in the U.S.
  
• One sign of our success in these markets is that our investment spending in Asia is paying off. We achieved positive operating leverage in our Asian Consumer business this quarter. One quarter ahead of when we expected it. We expect our Latin American Consumer business to follow next quarter.
  
• We continue to be very transparent about our U.S. mortgage exposure. We have a smaller own mortgage portfolio than any peer. Because of our aggressive risk mitigation efforts, which include selling mortgages, our portfolio has shrunk faster than any peer.
  
• Regarding Citi Holdings, we've decided to move the vast majority of our retail partner CARD business to Citicorp. We've made a lot of progress in strengthening this portfolio including shedding some assets and re-underwriting the portfolio to much higher credit standards.
  
• The portfolio is now two-thirds of its size at its peak, with an average balance weighted FICO of more than 700. In addition, so far this year, this business has earned a $2.2 billion profit before taxes, and is a powerful source of ongoing profits.
  
• As importantly the Credit Card business and the availability of credit have changed since the enactment of the CARD Act, consumer behavior has also changed. As branded cards carry smaller open lines and consumers would ratheruse retail cards to preserve and protect their open lines of credit with banks.
  
• With this transfer, pro forma Holdings assets will total about $250 billion, or 13% of Citi's balance sheet. Although we continue to analyze the Holdings portfolio, we don't expect any other transfers of this magnitude and our goal is to get Holdings below 10% of the balance sheet in the near future.
  
• Next, Citi has built unquestionable financial strength over the past several years. At the end of the third quarter, our Tier 1 common ratio was 11.7% and we had approximately $145 billion in tangible common equity. Almost 25% of our balance sheet is cash or liquid securities. We have enough liquidity that we could operate without issuing long-term debt for a couple of years, although we still plan to participate in the debt markets.
  
• We still expect to end 2012 with the 8% to 9% Basel III Tier 1 common ratio and meet the Basel III capital requirements ahead of schedule. Subject to regulatory approval, we still plan to begin returning capital to shareholders next year.
  
• Let me spend minute on expenses. Third quarter expenses were 12.5 billion in total, down 4% from the second quarter. After the big reductions in head count and cost over the last couple of years, we continued to actively manage our expense base.
  
• Looking forward, we expect our fourth quarter expenses to be roughly flat. Although the impact from episodic items such as FX and legal costs are not predictable.
  
• (John C. Gerspach, Chief Financial Officer) Citigroup reported third quarter net income of $3.8 billion or $1.23 per diluted share. This quarter's results included significant CVA of $1.9 billion, driven by Citi's credit spreads widening. Excluding CVA, earnings were $2.6 billion, or $0.84 per share in the third quarter. Revenues of $20.8 billion were roughly flat versus the prior year on a reported basis.
  
• Excluding CVA from both periods, revenues were down 8% as continued strong growth in international Consumer Banking and Transaction Services was more than offset by lower revenues in Citi Holdings, Securities and Banking, and North America Consumer Banking.
  
• Expenses of $12.5 billion were up 8% year-over-year and down 4% from last quarter. Year over year roughly three-quarters of the increase was driven by the impact of foreign exchange, higher legal and related costs and the absence of one-time benefits in the prior period. Excluding these items, operating expenses grew 2% year over year in the third quarter.
  
• Cost of credit continued to improve year-over year, down 43% to $3.4 billion. Sequentially, end-of-period loans declined 2% for Citigroup. However, reported loans included a net negative impact from foreign exchange in the third quarter. On a constant dollar basis, total Citigroup loans were up 1% sequentially as loan growth in Citicorp more than offset the decline in Citi Holdings.
  
• CVA was a significant factor this quarter at $1.9 billion pre-tax, compared to $164 million in the second quarter, and $115 million in the third quarter of last year. The $1.9 billion of CVA this quarter included $1.6 billion of CVA on Citi's fair value option debt, and roughly $300 million of derivative CVA net of hedges.
  
• In the second quarter of 2011, we also recorded over a $0.5 billion of realized gains, on the sale of assets transferred out of held-to-maturity in the special asset pool. And in the Q3 of last year, we had a net loss on the announced sale of Student Loan Corporation of $800 million.
  
• Turning now to Citicorp and Citi Holdings on Slide 4, Citicorp reported revenues of $17.7 billion and net income of $4.6 billion in the third quarter versus last year, Citicorp loans grew 13% on a reported basis, including 6% growth in Consumer, and 21% growth in Corporate loans.
  
• Citi Holdings reported revenues of $2.8 billion, and a net loss of $802 million. Citi Holdings ended the quarter with $289 billion of assets, down $19 billion during the quarter and $132 billion year-over-year.
  
• Operating expenses of $9.8 billion were up 9% versus the prior year and down 3% from last quarter. Year-over-year roughly a quarter of the increase resulted from the impact of foreign exchange.
  
• Citicorp's net credit losses were $1.9 billion, down 36% from the prior year driven by Citi-branded cards in North America. We released $585 million in net loan loss reserves, up from $426 million last year due to higher net releases in Citi-branded cards, partially offset by lower releases in international consumer banking and in net build in the corporate portfolio each driven by loan growth. Excluding CVA earnings before taxes of $4.6 billion were roughly flat versus last year as lower revenues and higher operating expenses were offset by lower credit costs.
  
• North America consumer banking: Revenues of $3.4 billion were down 9% versus last year mainly due to a decline in average card loans, lower mortgage revenues and the impact of the look back provisions of CARD Act. Sequentially, revenues were up slightly again this quarter by 2%. Expenses of $1.8 billion were up 24% year-over-year and 2% sequentially as we continued to make investments largely through higher marketing and technology spending.
  
• Credit costs declined 75% from last year to $509 million. Net credit losses were down 41% to $1.2 billion, driven by Citi-branded cards and the reserve release with $653 million this quarter. Net credit margin grew by 28% year-over-year to $2.3 billion.
  
• Earnings before tax, excluding the impact of loan loss reserves, grew by 45% to $445 million in the third quarter.
  
• For the second consecutive quarter we grew both CARD accounts and end-of-period loans on a sequential basis. Year-over-year purchase sales and CARD accounts both grew by 2%.
  
• Spread compression continued to be a headwind in the third quarter, but it is abating. On a sequential basis revenues were roughly flat as 2% underlying growth was offset by a net negative impact from foreign exchange.
  
• A lower net reserve release resulted in an increase in credit costs at $720 million versus $352 million last year. Net credit losses declined 9% to $691 million while the reserve release was just $9 million this quarter versus $440 million last year. Net credit margin of $4.1 billion was up 14% year over year. Earnings before tax excluding the impact of loan loss reserves grew by 20% to $1.2 billion.
  
• On a reported basis, average deposits and loans grew by 11% and 16% year over year respectively. Investment sales were up 1% versus last year and card purchases grew 20%. On a trailing 12-month basis, we have grown both net credit margin and pre-tax earnings excluding the impact of loan loss reserves in every quarter for two years.
  
• Asia consumer portfolio: Asia Consumer Banking represented nearly $85 billion of loans at the end of the third quarter with over 80% in emerging markets. As we have grown our loans in Asia in a careful and consistent manner with strict underwriting criteria and the benefit of decades of local experience in these markets.
  
• In Korea for example, LTVs are capped at 60%. In Singapore, LTVs are capped at 80%. And in Hong Kong, LTVs are capped at 50% to 70% based on property value. In each of these three portfolios, Citi's average updated LTV is roughly 50% or lower. Mortgages in these markets are also full recourse.
  
• As a result of the high quality of our borrowers and low LTVs in the region, our average historical NCL rate for mortgages in Asia has been close to 0%.
  
• Latin America consumer banking represented $35 billion of loans at the end of the third quarter. Mexico was over 60% of the total and Brazil was roughly 20% of loans. Cards represented 37% of the portfolio with an NCL rate of 8.4% in the third quarter. Mexico cards is roughly $5 billion and has been repositioned over the past three years with a focus on tighter underwriting criteria, and increased penetration of our existing retail base.
  
• Brazil cards is roughly 4.6 billion, and has migrated to a higher percentage of transactors who tend to have better credit quality. The Brazil market is facing regulatory changes including a significant increase in the minimum payment due, which will continue to put pressure on NCL rates in the near term. However, we currently believe the underlying credit quality of our portfolio remains stable. Commercial loans are about 31% of the portfolio, mostly in Mexico, where NCLs have averaged less than 1% over the past two years.
  
• Securities and Banking business. Excluding CVA, revenues of $4.8 billion were down 12% from last year, and down 9% versus the prior quarter. In Investment Banking, revenues of $736 million were down 32% sequentially, driven by lower activity levels across all products. X-CVA, equity market revenues of $289 million were down 63% sequentially. While cash equity revenues were relatively stable, we had weak trading performance in our equity derivatives business. We also incurred losses in principal strategies driven in part by the ongoing wind down of its positions.
  
• Fixed income market revenues x-CVA were down 22% sequentially to $2.3 billion, as strong growth in rates and currencies was more than offset by lower revenues in credit-related and securitized products. Lending revenues were $1 billion, up from $356 million last quarter, due to gains on hedges. Private bank revenues excluding CVA were down 2% sequentially to $545 million.
  
• Moving to Transaction Services: Revenues of $2.7 billion were up 7% from the third quarter of last year driven by international growth. Treasury and Trade solutions was up 5% primarily due to higher trade revenues in increased deposits, partially offset by the impact of the continued low rate environment. Securities and Fund Services grew 11% year-over-year, driven by strong growth in transaction and settlement volumes as well as new client mandates. Transaction volumes and new mandates continued to show momentum in both businesses.
  
• Asset growth was driven by trade loans with average trade assets up over 50% from last year. Average deposits were up 7% year-over-year, to $365 billion. Assets under custody were up 1% year-over-year to $12.5 trillion but were down 7% from the prior quarter, due to a negative impact from foreign exchange and lower market values. Expenses of $1.4 billion were up 17% versus last year, reflecting higher volumes in continued investments partially offset by productivity savings.
  
• Non-interest revenue was only $8 million this quarter, compared to nearly $1.2 billion last quarter, which included over $0.5 billion of gains realized on the sale of assets which had been transferred out of held to maturity earlier this year as well as realized gains on other asset dispositions.
  
• Operating expenses were down 6% year-over-year to $2.1 billion due to declining assets. Credit costs were down 40% year-over-year to $2 billion as credit trends continued to improve in both the consumer and corporate portfolios. Total net credit losses were down 44% to $2.6 billion as we released $838 million of net loan loss reserves in Citi Holdings.
  
• Corporate Other segment: Revenues declined by $296 million versus last year mainly driven by lower investment yields, lower gains on sales of AFS securities and hedging activities. Expenses were up by $217 million versus last year, mainly due to legal and related costs and infrastructure investments. Assets of $283 billion include approximately $93 billion of cash and cash equivalents and $121 billion of liquid available for sale securities.
  
• We summarize our country risk exposure to Greece, Ireland, Italy, Portugal and Spain, noted here as GIIPS, as well as France and Belgium. At the end of the third quarter Citi's gross-funded exposure to GIIPS was $20.6 billion and our combined gross-funded exposure to France and Belgium was $14.4 billion. Netted against our gross funded exposure we have margin posted under legally enforceable margin agreements, collateral pledged under bankruptcy remote structures and purchase credit production from financial institutions. These amounts totaled $13.5 billion for GIIPS and $12.4 billion for France and Belgium.
  
• Even in a continued low rate environment we currently anticipate achieving positive operating leverage in Transaction Services by the second or third quarter of 2012. In North America Consumer Banking we continue to benefit from declining credit costs this quarter. However, these improvements will likely slow into next year as we approach more normalized levels. Absent a material weakening of the U.S. economy we currently anticipate achieving positive operating leverage in North America Consumer Banking by the end of 2012.
  
• Our major focus in Citi Holdings will remain on managing the risks inherent in the U.S. mortgage portfolio. We expect ongoing weakness in U.S. housing into the middle of next year. Foreclosure backlogs continue to grow and the economic outlook is uncertain. Additionally, litigation and regulatory risk will remain high in the mortgage business, although given the size of our portfolios, we believe our exposure is smaller than peers.
  
• (Q&A) Curious, John, on your comments on reshaping the investment bank for the opportunities that you see. Obviously in a tougher revenue environment now. But expenses have been elevated there. I'm just curious: what drives the decision? Meaning if you go there and you shrink a little, is it Basel III? Is it Volcker? Is it the derivatives rules? What are the main drivers that's going bring rethinking on the IB or Securities and Banking? (A) And I think, yes, it's all of the above. You got to start right there which is Basel III, Volcker, are definitely going have impact on the kind of business here. You're in the credit businesses like securitization, some of the derivatives businesses, those that are non-clearinghouse counterparty businesses are going be affected by that. You got to scale for that. That's important. On the other hand, the expenses are going to be higher because if you want to be in clearinghouses you got to make sure the systems are set up. So on one hand, you reduce the business. On the other hand, on a getting ready for it basis, the expenses are higher. And none of us truly know where the Volcker rules are going to come out. They are going to have impact and we need to watch that but in our own case, as I'm sure elsewhere, we've been getting ready for that, making sure that we can comply with the definitions of proprietary trading and other activities. So those are clearly the case. The bigger issue is whether we all are going to see a secular change in the level of activity in those businesses. You and I know that's a really hard to predict. We all are living in environment where the interest rates are 2%. And on the other hand, we're expecting some of these businesses to return some very good rates of return. Now how that all squares, we're going to have to see and that's probably the most uncertain part. The part that we're more certain about is that capital markets activities, albeit slowly and albeit in a smaller volume to date, are moving the emerging markets. It's the emerging market companies that are doing the IPOs. It's the emerging market companies that are going to need the issuance of debt and all of the M&A that goes with that and that's one of those businesses that we are investing against as a company. So you can see it's sort of a picture with a lot of factors that are changing which means that you got to be right on top of the business making sure you're sizing the business correctly and optimizing it to where we think activities going to come from and taking some guesses as to what the secular level of activity is going to be.

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