After the Stress Tests: Now What?

It may be a long, hard slog for shareholders of Citigroup (NYSE:C) and the other three companies that failed the Federal Reserve’s stress tests. Without any hope for returning capital to shareholders for this year, the four banks run the risk of falling behind.

There’s still good news, though: 15 of the 19 banks passed the tests, meaning they might start being more aggressive in how they use their money.

The bad news is, the big banks have been hitting their profit numbers by using all sorts of accounting moves to paper over losses. Without these moves, and with real estate and European debt still hamstringing their balance sheets, banks like Citigroup and Bank of America (NYSE:BAC) will have a tough time trying to raise their dividends or do stock repurchases. Bank shares trade well below asset values, some at 40% of tangible book value, like Bank of America, meaning investors may expect big writedowns in the future.

The accounting moves include wonky sounding things like debt valuation adjustments, sluicing loan loss reserves back into income, and relying heavily on tax losses to lower tax bills to the IRS and thus boost reported profits. Two-thirds of Citigroup’s $21.9 billion in total net income for the last two years came from accounting moves.

To do its stress test, the Fed used a U.S. unemployment rate as high as 13% and a 20% drop in home prices, as well as an 8% drop in U.S. GDP -- which the U.S. saw in the 2008 downturn, and prior to that, in 1931-1932, notes bank analyst Richard Bove.

Insiders at Citigroup have told FOX Business that the bank has wanted to increase its dividend from a penny to a dime, and also execute a stock repurchase plan. Citi’s chief executive, Vikram Pandit, said last week at an investor conference that a stock buyback plan looks “attractive.” Nomura Securities had also forecast a dividend hike and new stock repurchase plan at Citi. One of the bank’s biggest investors, Prince Al-Waleed bin-Talal, has publicly endorsed a bigger dividend.

But Citi is still loaded down with first-lien mortgages, home equity loans, commercial and industrial loans, and credit card debt. All told, the Fed projected $134 billion in loan losses at Citi from 2011 through 2013 in its worst-case scenario.

For all the banks, the Fed estimated $324 billion in total post-provision losses in its stress-test scenario. Banks still have to deal with 11 million homes in negative equity, with some $700 billion in possible losses there, according to CoreLogic -- showing the recent $26 billion mortgage settlement is a drop in the bucket.

And overall, the U.S. banking system faces hundreds of billions of dollars in problematic home equity loans, too, says bank analyst Christopher Whalen.

A Citi exec says the bank is still operating in “an incredibly bureaucratic manner -- our operating expenses are still way too high because we have too many layers.”

Citi is stuck trading at the same levels before it split its stock one for ten; back that split out, and at around $3.50 it’s less than the cost of a Starbucks latte. Citi also received an historic bailout from the U.S. government valued at $306 billion, and has had three near-death experiences since 1980.

The Federal Reserve nixed Citigroup’s capital plan, which caused it to fail the central bank’s stress tests. Citi’s tier one capital ratios fell short by 0.1 percentage point, coming in at 4.9% versus the 5% minimum. Citi’s minimum stressed tier one common ratio was 5.9% before its proposed capital actions, vs. 5.7% for Bank of America and 6.3% for JPMorgan Chase (NYSE:JPM).

Shares of Citi promptly fell 5% after hours on the news it failed the test, wiping out the 5% runup in the final minutes of yesterday’s trade.

Citi blasted an email to the media yesterday, and put up this statement on its bank blog:

“Simply put, the Federal Reserve's objection to our capital plan does not equate with 'failing' the stress test. As of the end of 2011, Citi had a Tier One Common ratio of 11.8% and remains one of the best capitalized banks in the world.”

But again, what’s missing here is how Citigroup has deployed accounting moves to help paper over its losses from its equity trading desks and investment banking division, as well as its sour assets housed at its bad bank, Citi Holdings.

Specifically, Citi drew down a total of $13.9 billion out of its cookie jar loan-loss reserves over the past two years, letting them flow into its bottom line. It reported $21.9 billion in total net income for 2011 and 2010.

Its $1.2 billion reported net profit for the fourth quarter 2011 would have been a deeper loss without this move. Also, Citigroup says its fourth quarter total provisions for credit losses and other claims dropped 41% from the fourth quarter of 2010, to $2.9 billion. That figure includes a $1.5 billion drawdown from its loan loss reserves.

Citigroup’s 2011 results also benefited from a paper gain of $1.8 billion, reflecting a sharp increase in the perceived riskiness of its debt -- a move that JPMorgan Chase and Bank of America have also used.

And Citi has benefited mightily from its losses, which it has built into an asset to reduce its tax bills to the U.S. government. In turn, that makes its profits look better.

Companies including Citi get to book these losses as assets, called “deferred tax assets,” on their balance sheet. They then can use these losses to lower their taxes in the future, meaning, when they start making taxable profits again. But normally, companies that go bankrupt can’t use those assets to reduce their tax bills. However Citi, as did Fannie Mae and Freddie Mac, got a pass here when Congress rescued these companies and essentially kept them bankruptcy, allowing the use of these DTAs for insolvent companies.

But what’s funky here too is that Citi and other companies get to include these DTAs in their tier one regulatory capital, a highly questionable practice.

Capital should be solid capital, not paper gains.

Moreover, Keefe, Bruyette & Woods notes there’s another game here for banks on the brink with their DTAs.   Banks often book reserves against their DTAs, in case they can’t use them. When they can’t use them, then they get to sluice right back into earnings those reserves, too. Again, not solid, organic earnings growth.

Separate from the moves, banks have been struggling to make money ever since the Federal Reserve has had a virtually zero interest rate policy, which means the central bank has effectively nationalized the yield curve to save the U.S. economy from the plunging housing market.

The Federal Reserve noted that the 19 banks would generate a paltry 2.5% of their assets in net revenue in its bombed out stress scenario, or $294 billion in pre-provision net revenue, largely because of the “low interest rate, flat yield curve environment.”

Low rates have wrecked the banking system’s incentive to create credit by reducing the opportunity for banks to leverage a positively sloped yield.

And banks still face all sorts of write downs from real estate. Whalen estimates the Fed’s projection of $56 billion in total losses for all the banks it stress tested “is way, way too small” if housing is going to fall another 20%. He says: “Try more like $200 billion.”

In fact, “you could haircut Wells Fargo and Citigroup’s second lien portfolios by $50 billion each today,” given where the housing stands, he says.

And, he questions the “mere $62 billion loss on first lien mortgages in the supervisory stress scenario,” since “real estate is half the total $13 trillion balance sheet of the US banking system and more like three-quarters of total exposure if you include RMBS (residential mortgage-backed securities), how does the Fed manage to keep total real estate losses below $150 billion in the stressed scenario?”

Of course, there’s more coming from exposure to Europe. And it’s not just because US banks face tremendous pressure because a number of European Union countries have banned short selling against their banks, while at the same time they’ve effectively nationalized their big banks.  That’s sent the short sellers running to U.S. banks, putting pressure on stocks.

But more so, U.S. banks have an estimated loan exposure to German and French banks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641 billion, according to the Bank for International Settlements, so a collapse of a major European bank would be a significant hit to the U.S. banking system.

Which was a scenario under the Fed’s stringent stress tests.