A bank fighting for credit: Massive bad loans and pressure from the US regulators will soon put Citibank at a considerable disadvantage to its main rivals, writes Michael Marray in New York

THE PAST week has been a deeply wounding one for Citibank - still, but only just, America's largest bank. The sudden resignation of its president, Richard Braddock, and then a warning of worse than expected third-quarter earnings combined to send its share price into a skid.

The double dose of bad news is severely testing investor confidence in Citibank. The poor performance is particularly ominous against the background of steadily deteriorating conditions in the already stricken US banking industry. It may even mark the beginning of the end for John Reed, the chairman who was regarded as the wunderkind of US banking in the 1980s.

The official Citibank explanation, that Mr Braddock chose to resign because he 'wants to pursue new career opportunities', has been greeted with scepticism on Wall Street, and the rumour mill is working overtime.

Was he a sacrificial lamb offered by Mr Reed to save his own skin? Could Mr Reed, under pressure from regulators or the Citibank board - or both - soon be on the way out?

The current crisis ends a summer during which Citibank has appeared to go into reverse gear after making considerable progress during the first half of 1992. Its share price, which reached dollars 21 in early July from a dollars 9 low last year, closed at dollars 14.50 on Thursday in New York after heavy selling during the week.

The root of Citibank's problems is its huge collection of non-performing loans - dollars 10.4bn ( pounds 5.8bn) worth at the last count, mostly concentrated in commercial real estate and residential mortgages.

Citibank leapt out of the frying pan and into the fire during the late 1980s, when, leading the way in a resolution of the Latin American debt crisis, it moved heavily into real estate lending, taking the most aggressive stance of any US bank in residential mortgage lending.

As a consequence, Citibank ended with more bad loans than other banks when the US real estate market collapsed.

Even worse, its management has been rapped over the knuckles by the US regulatory authorities for what they regard as sloppy supervision and lax credit control in mortgage lending practices. These criticisms were contained in a confidential report leaked to the press last month.

The ensuing bad publicity came only a few weeks after bank regulators forced Citibank to adjust downward its released second-quarter earnings and to reclassify loans that were more than one year in arrears as bank-owned real estate rather than mortgage loans.

The pressure is a sign that US bank regulators are taking a much tougher line, partly as a result of the crisis in the Savings and Loans industry that will eventually cost taxpayers more than dollars 100bn.

According to some analysts, the banking industry is sliding towards the same abyss as the S&Ls because of the government's refusal to admit the severity of the problem.

A book published last week by Edward Hill, a professor at Cleveland State University, and Roger Vaughan, a banking expert, claims that one in six US banks is technically insolvent and more than 1,000 'are dying'. Banking on the Brink says the eventual cost to the taxpayer could also be around dollars 100bn.

As a first step to avert disaster, the Federal Deposit Insurance Corporation Improvement Act will soon come into force.

The new law is designed to minimise the potential liabilities of the FDIC - which insures individual deposits of up to dollars 100,000 in about 12,000 US banks - by encouraging regulators to take early action against institutions with financial problems, instead of waiting for them to collapse and picking up the tab - often what happened during the S&L debacle.

'The law mandates harsh, rapid action to be taken against weaker banks and is less subject to discretion,' explained Brent Erensel, vice-president at Union Bank of Switzerland in New York.

'It will force weaker banks to do one of two things - strengthen their capital base or become part of a larger organisation,' Mr Erensel said.

Under the guise of 'prompt corrective action', bank regulators will be required to take increasingly severe measures as a weak bank falls below internationally agreed capital adequacy standards.

Those standards demand that a bank must maintain a risk-weighted capital adequacy of at least 8 per cent of its loans (assets). Under the FDICIA, usually referred to as 'Fidicia' by regulators, banks whose capital adequacy falls below 8 per cent will have to file a capital restoration plan and can have their loan growth restricted.

Below 6 per cent, a range of other measures can kick in - including forced recapitalisation or merger.

Most attention, however, has been paid to the action mandated by the FDICIA for banks that slip into 'zone five', defined as where tier one or core capital, which must make up at least half of the overall 8 per cent capital adequacy cushion, drops below 2 per cent.

The descent into zone five will mark the point of no return for US banks, since the authorities will be required by law to put the institution into receivership within 90 days.

The new law takes effect from 19 December, meaning that bank closures are to be expected by the middle of next March. According to Ellen Stockdale at the office of the Comptroller of the Currency in Washington DC, up to 100 banks could go.

This would mean a busy first quarter next year for the insurance corporation - since so

so far this year there have been a total of 85 bank failures (down from 124 in 1991, and 168 in 1990). One estimate suggests that the immediate effect of the FDICIA will be to close banks with combined assets of dollars 30bn.

A report from Union Bank of Switzerland tips First City Bancorporation of Houston and Constellation Bancorp of New Jersey as two likely casualties.

UBS also highlights the opportunities that are likely to arise for stronger banks to take over weaker institutions.

This is precisely where Citibank stands to lose out, finding itself unable to expand at a time when many competitors are on the acquisition trail. A report from Salomon Brothers issued earlier this year suggests that Citibank's loan loss provisions will remain high through the first half of the decade, 'as management, likely driven by the regulators, pumps the reserve to levels in line with its industry peers'.

Citibank currently has reserves equivalent to 38 per cent of its non-performing loans, while Chemical Bank has 48 per cent coverage and Bank of America has 75 per cent set aside. Citibank's risk-adjusted capital ratio is 8.5 per cent, while Chemical Bank's stands at 10.8 per cent, and Bank of America's at 10.4 per cent.

As a result, while many of its rivals are in zone one and classified under the FDICIA as 'well capitalised', Citibank is categorised only as 'adequately capitalised' and is uncomfortably close to being an 'under capitalised' zone three bank.

In fact, Citibank has been operating since early this year under close supervision from banking regulators, who have the discretion to block any acquisitions or expansion of Citibank's assets.

Some analysts argue that in order to move comfortably above the 8 per cent risk-adequacy floor, Citibank needs a large dollars 1bn-plus offering of common stock.

With the bank's share price once again languishing well below its book value of around dollars 21 a share, however, they recognise that such a move is not currently feasible.

In an attempt to improve its capital position, Citibank is about to launch a dollars 650m issue of preferred stock, but the resignation of Mr Braddock has done little to help the marketing process that is currently under way. Clearly, many investors have been alarmed at the sudden departure of Mr Braddock, particularly given the perception that he was Mr Reed's closest friend and ally at Citibank.

Citibank's future may depend upon an improvement in the economy. Despite a good year for bank operating profits, which have benefited from record net interest margins as base rates have been slashed, there is little demand for new loans and existing loans continue to turn bad.

'This is going to be a three to five-year workout period for most banks with large commercial real estate portfolios,' said Robert Swanton at the rating agency Standard & Poor's.

'The vast majority of banks, and particularly those along the east coast and west coast where there was a real estate boom, are going to continue to have modest-to-weak financial performance over the next year or two, reflecting continued write- downs in real estate,' Mr Swanton said.

Citibank continues to be a source of more disappointment to analysts, however, than its competitors. Wall Street had been anticipating third-quarter earnings to come in at around 25 cents per share, but Citibank has said that earnings will be somewhere between 8 and 13 cents per share, or dollars 80m-dollars 100m.

The difference is mostly accounted for by a restructuring charge of dollars 65m, but there was also a dollars 90m charge for mortgage-related assets. Meanwhile, general loan provisions remain high at dollars 870m for the quarter, although these are in line with expectations.

The bad results come in spite of strong results from foreign exchange dealing during the third quarter, as Citibank used its position as a global forex powerhouse to make substantial profits during the European currency crisis in September. 'They are lousy earnings, whether it is 8 or 13 cents a share,' is the verdict of one analyst with a New York broking house.

Lousy or not, for the moment Citibank retains its ranking as the largest US bank, with assets of dollars 220bn. In second place is Bank of America, which after its acquisition of Security Pacific has assets of dollars 190bn, and third is Chemical Bank with assets of around dollars 140bn following its merger with Manufacturers Hanover.

Bank of America is still behind, but with Citibank concentrating on raising capital and loan provisions - and hobbled by the regulators - it has a chance to make a serious challenge for the top spot during the next few years.

(Photograph omitted)