Oct. 12 (Bloomberg) -- Citigroup Inc. and U.S. banks that hunkered down following 2008 bailouts are expanding into new businesses and markets, bringing higher expenses that may erode profit margins before they yield shareholder returns.
Citigroup Chief Executive Officer Vikram Pandit is adding 7,500 staff in China over the next three years. He also plans to recruit 100 commodities traders and double private bankers in North America to almost 260. The company last month promised $9 million to a Houston-based investment banker to lure him from UBS AG, according to a person with knowledge of the matter.
Banks are loosening budgets this year as they seek to compensate for shrinking loan books, caps on credit-card charges and overdraft fees and a ban on trades with their own money. With returns yet to come on new investments, the added expenses are rising faster than revenue.
“Investors would not be big fans of banks bringing down near-term returns on the promise that they’ll grow revenue in the future,” said Thomas Brown, CEO of hedge fund Second Curve Capital in New York, which oversees about $250 million in bank stocks, according to a regulatory filing. “They’d rather see revenue growth out of the existing franchise.”
First-half operating expenses at the six biggest U.S. financial firms by assets -- Bank of America Corp., JPMorgan Chase & Co., Citigroup, Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley -- grew by $7.92 billion, or 5.9 percent. Revenue fell by $5.6 billion, or 2.2 percent.
The toll of rising operating costs may become clearer over the next two weeks as the six banks announce third-quarter results. JPMorgan, based in New York, is scheduled to report tomorrow, with the rest to come next week. A bank’s operating costs include personnel, as well as office space, equipment, marketing, advertising, consulting fees, data processing and telecommunications.
Overall, the six banks are expected to report a combined profit of $11.8 billion, the average estimate of analysts surveyed by Bloomberg. That would be an increase of 19 percent from a year earlier, mainly because of lower loan-loss provisions, which banks count separately from their operating expenses. The estimated third-quarter profit would be down 28 percent from the second quarter.
At New York-based Citigroup, which got a $45 billion bailout in 2008 amid mounting mortgage losses, new spending should be monitored closely given the company’s track record of ill-timed investments and inadequate risk management, said Mike Mayo, an analyst at Credit Agricole Securities USA in New York who rates Citigroup “underperform.”
Hong Kong Taxis
“The burden is on Citigroup to show that it can invest for sustainable growth,” said Mayo. “We’ve heard many stories from Citigroup over the past decade about expansion, whether in investment banking or Japanese consumer finance or other areas that failed to pan out.”
On a trip to Hong Kong in September, Mayo said, he was greeted at the airport by three taxis in a row with rooftop advertisements for Citigroup’s Citibank unit. “I hit the trifecta,” he said.
Investors analyze companies’ operating leverage -- the ability to grow revenue faster than expenses -- to gauge whether expansion into new businesses translates to higher earnings per share. Negative operating leverage is when expenses grow faster than revenue. In the second quarter, one-third of the large and medium-size banks in the U.S. had positive operating leverage, compared with half in the prior quarter, Jason Goldberg, a Barclays Capital analyst in New York, wrote in an Oct. 8 report.
“We expect operating leverage to remain challenging in the second half of 2010 amid revenue pressures, in part due to regulatory changes,” Goldberg wrote.
Citigroup’s overhead ratio -- operating expenses divided by revenue -- jumped to 54 percent in the second quarter from 45 percent in the first and 40 percent a year earlier. The measure was 58 percent at JPMorgan in the second quarter, 59 percent at Bank of America and 60 percent at Wells Fargo.
Pandit, 53, slashed costs last year by cutting jobs and shedding businesses, including the Smith Barney brokerage, the Primerica life insurance network and the Nikko Cordial securities unit in Japan.
The bank had 259,000 employees as of June 30, down from 371,000 in 2007 just before Pandit took over following the ouster of Charles O. “Chuck” Prince, 60. Operating expenses totaled $47.8 billion last year, a drop of 19 percent from 2007.
“They’ve been working very hard at the expense part of the equation and have gotten that to a pretty good level,” said Tanya Azarchs, former head of North American bank research at Standard & Poor’s and now a consultant in Briarcliff Manor, New York.
The company last year repaid $20 billion of the bailout money and converted the remaining $25 billion into common stock. The Treasury Department has been selling the stock this year, with an initial stake of 7.7 billion shares whittled to 3.6 billion as of Sept. 30. The remaining stake amounts to about 12 percent of the bank’s outstanding shares.
Citigroup shares have climbed 26 percent this year, more than double the 11 percent gain in the KBW Bank Index, which tracks 24 of the largest banks’ stocks.
Pandit and his team have cut assets by 28 percent in the Citi Holdings division, created last year to hold businesses tagged for exit. In the meantime, he’s ramped up spending in the Citicorp division, which includes businesses he calls “core” to the company’s stated mission of being “America’s global bank.” They include securities trading, investment banking, branch banking, credit cards and corporate cash management.
“We continue to focus on managing expenses, which includes investing in our core franchise with a particular emphasis on opportunities that complement and leverage our global footprint and unique network,” said Shannon Bell, a bank spokeswoman.
Many of Citigroup’s new hires are in emerging markets, where economic growth may be more than three times the pace of developed markets, Citigroup Chief Financial Officer John Gerspach said in February. During a conference call with investors in July, Pandit said the company had “lots of plans” for expansion.
“They are in not only Latin America, but we’re doing it in Hong Kong, and we’re doing it in other parts of Asia,” Pandit said. “We’ve got a lot of these opportunities, and we’re going after them very diligently.”
Citigroup hired 9 people for stock trading in India in February, and in March the company announced 13 new hires for prime brokerage, the business of clearing trades for hedge funds and lending them securities. Last month, Citigroup said it hired 15 equities traders, salespeople and researchers to expand coverage of Russia, South Africa and the Middle East.
Stephen Bird, co-CEO of the company’s Asia-Pacific region, said in August that the bank would increase its China workforce to 12,000 people from 4,500 over the next three years. The eventual staff would outnumber the estimated 8,000 terra-cotta soldiers buried alongside the country’s first emperor two millennia ago to guard him in the afterlife.
“We have aggressive consumer-banking expansion plans and want to open branches as fast as regulators in China will let us,” Bird said.
Citigroup’s overall first-half operating costs fell 1.3 percent from a year earlier to $23.4 billion, while revenue dropped 13 percent, mostly from the wind-down of Citi Holdings. In the Citicorp division, costs rose by 14 percent, as revenue declined by 3.6 percent.
JPMorgan, Morgan Stanley
JPMorgan’s operating costs rose 14 percent in the first half, outpacing a 4 percent increase in revenue. The bank is trying to double the size of its investment bank in Asia and has expanded its commodities-trading unit this year.
Costs at Charlotte, North-Carolina-based Bank of America increased by 3 percent, as revenue fell by 11 percent. Wells Fargo, based in San Francisco, had a 1.4 percent increase in expenses compared with a 1.6 percent drop in revenue. While expenses at New York-based Goldman Sachs fell by 3.3 percent, revenue dropped by 6.8 percent.
Morgan Stanley was alone among the six banks in posting first-half revenue growth that outpaced costs. Revenue more than doubled from a year earlier as trading results improved. Operating costs climbed 38 percent, in part because the New York-based firm set aside more money for year-end bonuses.
Spokesmen for the other five banks declined to comment.
It’s not just the costs of developing new businesses that are hitting the bottom line, said Peter Kovalski, a portfolio manager at Alpine Woods Capital Investors LLC in Purchase, New York, which oversees about $6 billion, including investments on Bank of America, JPMorgan, Citigroup and Goldman Sachs. Banks are still paying to clean up after the credit crisis, he said.
“There are a lot of legal fees and appraisal fees, which naturally come up as you work through problems,” Kovalski said.
Goldman Sachs in July agreed to pay $550 million to settle a Securities and Exchange Commission fraud suit related to a mortgage-linked investment that later soured. Citigroup paid $75 million to settle claims it failed to adequately disclose subprime-mortgage holdings as the housing market deteriorated in 2007. Bank of America and JPMorgan have assigned staff to contest claims by Fannie Mae and Freddie Mac that they should buy back defective mortgages sold under warranty.
JPMorgan’s first-half compensation costs climbed 3 percent to $14.9 billion, marketing costs jumped 51 percent to $1.21 billion and other expenses more than doubled to $6.86 billion. At Bank of America, personnel costs were up 8.4 percent to $17.9 billion, and professional fees increased 22 percent to $1.16 billion.
“Assurance of Money”
Bank of America last month drew up plans to fire as many as 400 employees in its global banking and markets division because of a decline in revenue from trading and advising clients. Citigroup isn’t planning similar headcount reductions, a person briefed on the matter said last week.
Stephen Trauber, 48, the energy investment banker who in September was hired by Citigroup from Zurich-based UBS, said at the time that he brought his team, which included four other senior bankers and some junior bankers, because of the “assurance of money.”
While the “traditional relationship management” done by bankers such as Trauber isn’t as risky as the trading businesses that led to Citigroup’s bailout, “hiring a group is like buying a small company,” said Richard Lipstein, a managing director at headhunter Boyden Global Executive Search in New York. “It’s a bet that’s being made.”
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