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WaMu May Fit Best With Citi

Laurie Kulikowski

Despite a campaign to shed assets, Citigroup's (C Quote) pursuit of Washington Mutual (WM Quote) could be just what the financial giant needs to boost its floundering U.S. retail bank.

Citi has been one of several banks, along with JPMorgan Chase (JPM Quote), Wells Fargo (WFC Quote) and several foreign institutions such as Toronto-Dominion (TD Quote), named in media reports to have been considering some sort of deal with WaMu as it struggles to remain above water.

Speculation is high regarding the fate of WaMu, once the nation's largest thrift. While federal regulators are breathing down WaMu's neck to make a deal or raise capital, a private equity investment may be becoming less likely an option.

Citi CEO Vikram Pandit has pledged to shed roughly $400 billion of the firm's less important assets. But adding WaMu's attractive retail franchise could be just want the bank needs.

"In some ways I think Citi has more to gain because they need the branch network more than JPMorgan," says Bart Narter, a senior vice president of Celent's banking group, based in San Francisco. "I would say that Citi would inherently value it more."

"Citi could really use a bigger and better branch footprint in the U.S.," Narter says. "They would see WaMu as a very attractive way to get that quickly. There is some overlap in California ... but Citi is not very big."

Pandit is trying to steady the global financial titan's ship after Citi has taken its own billions in losses

Congress is also putting the final touches on a federal bailout program which is reportedly going to buy roughly $700 billion worth of troubled assets. Banks, including potential WaMu suitors, are eagerly awaiting how the bailout package would help their businesses. Any potential WaMu buyer is most likely waiting to hear how the bailout package would be structured to see how much of the thrift's mortgage portfolio the government is willing to take on.

WaMu played a heavy hand in the mortgage boom earlier in the decade and is now suffering from billions in losses from housing meltdown. The situation is growing increasingly dire at WaMu as investors are growing wary of the thrift's ability to find itself. WaMu recently assured the public that it indeed had sufficient capital. All three large ratings agencies have downgraded WaMu's debt ratings to junk status.

Clearly a main reason Citi would want WaMu is for its $143 billion in retail deposits throughout its 2,300-branch network located in 14 states.

Anton Schutz, president of Mendon Capital Advisors, the fund manager to Burnham Financial Services, agrees that a WaMu-Citi tie-up could make sense.

Pandit "is interested in the deposit side of this," Schutz says. "It's a whole lot cheaper than wholesale funding."

According to a CreditSights note on Monday, in which analysts explored various potential deals for WaMu, "[b]igger banks need to be the consolidators of the weaker banks with troubled real estate," it said. "We sense that deposit spread income is one of the only visible, critical mass forms of generating financial revenue over a longer period."

"This is why we believe it is so important for the big banks to get bigger on the deposit liabilities side so that they have the feedstock for revenue growth, namely deposit relationships/deposits," the note said.

Citi has approximately 1,000 branches in 13 states and the District of Columbia under its retail bank brand, Citibank. Those branches are located mostly along the East Coast, but also in Texas, Nevada, Illinois and California. Citi also has roughly 2,500 consumer finance branches across the U.S. and Canada under the brand CitiFinancial.

At the end of the second quarter, Citi's global consumer group contributed roughly 40% of its total $803 billion of deposits, which includes deposits across Citi's domestic and international business lines. Citibank specifically contributed roughly 15% of those deposits, according to the bank's latest quarterly filing with the Securities and Exchange Commission.

But average deposits at Citibank increased just 3% to $121.8 billion last quarter compared to a year earlier, the filing said.

In addition, Citi can extract large cost savings from WaMu's mortgage and credit card businesses, observers say.

Citi and WaMu, like JPMorgan Chase, are both huge players in mortgage and credit cards. For these business lines "scale is a lot" -- that's why Bank of America (BAC Quote) bought lender Countrywide to "bulk up in mortgages," Narter says.

"With credit cards, it's not just people, but gathering data on your customers and understanding buying behavior" and delinquency trends, he says. Essentially the larger share of the market, the more a company can "slice and dice" the data in order to be more profitable, "so building bulk in both of those businesses, even though they're not great businesses right now, is a good thing," Narter adds.

Still the question overhanging on WaMu, and basically what has been stopping any acquirer not just Citi from sealing a deal is the uncertainty regarding the Seattle thrift's mortgage and increasing credit card loss expectations. WaMu has said that it expects $19 billion in total losses over the next few years, but observers say those losses could be higher, depending on the environment.

WaMu has roughly $55 billion in risky option adjustable-rate mortgages, according to CreditSights. Average loans totaled $245 billion at the end of the second quarter.

Most banks are already struggling from their own exposure to bad mortgages and securities writedowns from the credit crisis. Citi in particular has taken massive writedowns and credit costs so far from the credit crisis.

The general deteriorating environment could give pause to Citi as it assesses its own exposures to troubled credits. A Citi spokesman declined to comment on rumor or speculation regarding a deal with WaMu.

"Citi has still some challenges before it, but the good news with Citi is they have some franchises that are performing extremely well at the moment," including global transaction services, which includes its cash management and treasury services business as well as certain retail and card services outside the U.S., says Jim Ekenrode, an analyst at TowerGroup.

"They're sort of holding steady at the moment," Eckenrode says. "It appears to me that things are somewhat okay."

At the end of the second quarter, Citi's Tier-1 capital ratio was 8.7%.

Meredith Whitney, an analyst at Oppenheimer, is less optimistic of Citi's ability to earn a profit this quarter. Whitney predicts that the firm will post a loss of 36 cents a share for the third quarter, slashing her original estimates by 42 cents, to "reflect deteriorating credit and [other] charges in the quarter," she wrote in a note.

Analysts are expecting Citi to earn just 3 cents a share in profit for the third quarter. If Citi hits earnings estimates, it will be the first time in four quarters that the financial titan made a profit, given the difficult banking environment.

Not everyone is sold on a potential Citi-WaMu merger.

"In contrast to our analysis of a combination with JPMorgan, a Citigroup-WaMu merger indicates that unless Citi were to acquire WaMu at a significant discount ... the transaction may not generate a desirable [internal rate of return]," the CreditSights note said.

The low internal rate of return is the result of "a large capital outlay due to mark to market adjustments and Citi's low stock price and price to book multiple," the note said.

Citi shares closed up 2.4% to $19.41 on Thursday, while WaMu shares closed down 25.2% to $1.69.