Citigroup's Bottom Line Needs a Housing Bottom

NEW YORK ( TheStreet) -- When Citigroup ( C) reports its third-quarter results Monday, analysts and investors will be hoping to see early signs that the bank is benefiting from the nascent housing recovery.

Citigroup is no longer a big originator of mortgages in the U.S., with its North American residential real estate portfolio largely in run-off mode at its non-core Citi Holdings unit.

But the bank is likely to continue to benefit from improving credit quality trends.

A widespread rebound in home prices has helped over a million underwater borrowers recover equity in their homes in 2012, according to CoreLogic. If the trend continues, banks could see lower delinquency rates in the future, reducing the amount of profit they need to set aside as a cushion against future loan losses.

This is largely priced in for bank stocks with a big exposure to mortgages, notably Bank of America ( BAC) and Wells Fargo ( WFC).

But some analysts point out that the market is underestimating how levered Citigroup is to a housing recovery.

"Despite its relatively small concentration of residential loans, C Citigroup has more upside to an improving housing market than investors believe," Goldman Sachs analysts wrote in a recent report. "The primary lever for C is lower credit losses in its North American real estate portfolio in Citi Holdings, where we estimate lower credit losses could be 12% accretive to EPS; even before factoring in additional reserve release."

The report adds that better home prices should allow for the quicker rundown of Citi Holdings, reducing its drag on the bank's financials.

" Citigroup would be the most inexpensive name in our coverage universe in a housing recovery scenario, trading at 5.9X," Goldman Sachs said.

Merrill Lynch's Erika Penala believes improving credit could benefit Citigroup's earnings per share by 19%.

Citigroup is well reserved for loan losses at more than 4% of loans, allowing it room to "release" a substantial portion of its reserves as charge-offs and provisions for future loan losses decrease.

Barclays Capital analyst Jason Goldberg notes that Citigroup has $9.5bn of reserves (30 months of NCO coverage) currently held against $100bn of residential mortgages. Timing for a reserve release appears close, according to the analyst as "stabilizing price conditions have helped place a floor under future losses."

On Friday, JPMorgan Chase ( JPM) beat expectations, helped in part by a $900-million mortgage loan-loss reserve release. Wells Fargo saw a reserve release of $200 million.

Besides offering earnings upside to Citigroup, Goldberg says reserve releases could increase tangible book and capital ratios, be a positive signal to the market and improve profitability at Citi Holdings, among other things.

While all this is grounds for optimism in the upcoming quarters, the third quarter for Citigroup is likely to be somewhat uninspiring.

Overall, the third largest U.S. bank is expected to post an operating profit of 96 cents per share in the third quarter on revenues of $18.707 billion, according to consensus estimates from Thomson Reuters.

The estimates exclude the previously disclosed $2.9 billion write-down of the firm's 49% stake in Morgan Stanley Smith Barney. Accounting gains/losses stemming from the revaluation of the bank's debt (DVA/CVA) have also been excluded from earnings forecasts.

The bank is expected to show improvement in capital markets revenue in the third quarter, while continuing international loan growth is likely to offset some of the margin pressure at home.

Concerns about a global slowdown and its effects on loan growth and borrower performance in emerging markets are likely to be addressed in the analyst conference call.

Analysts will also be looking for more clarity on the bank's buyback plans for 2013, after its request to return capital was rejected by the Federal Reserve earlier this year.

-- Written by Shanthi Bharatwaj in New York.
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