How Citigroup Got Into Trouble

“Risk comes from not knowing what you’re doing.” – Warren Buffett.

In previous posts, I wrote about the poor job some investment banks did in risk management and how they ended up “owning exotic securities, derivatives, pieces of paper backed by pools of assets. They did not understand these securities any better than the people they sold them to.

An article in today’s New York Times, The Reckoning – Citigroup Pays for a Rush to Risk, by Eric Dash and Julie Creswell goes behind the scenes to explain just how bad things were. What is fascinating is that the article names names, i.e. the people who were trading the securities and the risk managers, who failed to rein them in.

Of course, top management was ultimately responsible for the debacle.  Looking back, one question comes to mind, “What were they thinking?” The authors answer that question.

Here are extensive quotes from the article.

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.

There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.

Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.

For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.

Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

But many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

Today, Citigroup, once the nation’s largest and mightiest financial institution, has been brought to its knees by more than $65 billion in losses, write-downs for troubled assets and charges to account for future losses. More than half of that amount stems from mortgage-related securities created by Mr. Maheras’s team — the same products Mr. Prince was briefed on during that 2007 meeting.

Citigroup’s stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago. Waves of layoffs have accompanied that slide, with about 75,000 jobs already gone or set to disappear from a work force that numbered about 375,000 a year ago.

While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.

Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.

For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading.

But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses.

To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank’s balkanized culture and pell-mell management made problems inevitable.

“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”

Questions on Oversight

Though they carry less prestige and are paid less than Wall Street traders and bankers, risk managers can wield significant clout. Their job is to monitor trading floors and inquire about how a bank’s money is being invested, so they can head off potential problems before blow-ups occur. Though risk managers and traders work side by side, they can have an uncomfortable coexistence because the monitors can put a brake on trading.

That is the way it works in theory. But at Citigroup, many say, it was a bit different.

David C. Bushnell was the senior risk officer who, with help from his staff, was supposed to keep an eye on the bank’s bond trading business and its multibillion-dollar portfolio of mortgage-backed securities. Those activities were part of what the bank called its fixed-income business, which Mr. Maheras supervised.

One of Mr. Maheras’s trusted deputies, Randolph H. Barker, helped oversee the huge build-up in mortgage-related securities at Citigroup. But Mr. Bushnell, Mr. Maheras and Mr. Barker were all old friends, having climbed the bank’s corporate ladder together.

Because Mr. Bushnell had to monitor traders working for Mr. Barker’s bond desk, their friendship raised eyebrows inside the company among those concerned about its controls.

After all, traders’ livelihoods depended on finding new ways to make money, sometimes using methods that might not be in the bank’s long-term interests. But insufficient boundaries were established in the bank’s fixed-income unit to limit potential conflicts of interest involving Mr. Bushnell and Mr. Barker, people inside the bank say.

Indeed, some at Citigroup say that if traders or bankers wanted to complete a potentially profitable deal, they could sometimes rely on Mr. Barker to convince Mr. Bushnell that it was a risk worth taking.

Risk management “has to be independent, and it wasn’t independent at Citigroup, at least when it came to fixed income,” said one former executive in Mr. Barker’s group who, like many other people interviewed for this article, insisted on anonymity because of pending litigation against the bank or to retain close ties to their colleagues. “We used to say that if we wanted to get a deal done, we needed to convince Randy first because he could get it through.”

Others say that Mr. Bushnell’s friendship with Mr. Maheras may have presented a similar blind spot.

“Because he has such trust and faith in these guys he has worked with for years, he didn’t ask the right questions,” a former senior Citigroup executive said, referring to Mr. Bushnell.”

According to a former Citigroup executive, Mr. Prince started putting pressure on Mr. Maheras and others to increase earnings in the bank’s trading operations, particularly in the creation of collateralized debt obligations, or C.D.O.’s — securities that packaged mortgages and other forms of debt into bundles for resale to investors.

Because C.D.O.’s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.

“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’ “

It appeared to be a good time for building up Citigroup’s C.D.O. business. As the housing market around the country took flight, the C.D.O. market also grew apace as more and more mortgages were pooled together into newfangled securities.

From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.’s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry’s biggest players. Firms issuing the C.D.O.’s generated fees of 0.4 percent to 2.5 percent of the amount sold — meaning Citigroup made up to $500 million in fees from the business in 2005 alone.

Even as Citigroup’s C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars’ worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.
 

In 2005, as Citigroup began its effort to expand from within, Mr. Rubin peppered his colleagues with questions as they formulated the plan. According to current and former colleagues, he believed that Citigroup was falling behind rivals like Morgan Stanley and Goldman, and he pushed to bulk up the bank’s high-growth fixed-income trading, including the C.D.O. business.

Former colleagues said Mr. Rubin also encouraged Mr. Prince to broaden the bank’s appetite for risk, provided that it also upgraded oversight — though the Federal Reserve later would conclude that the bank’s oversight remained inadequate.

Once the strategy was outlined, Mr. Rubin helped Mr. Prince gain the board’s confidence that it would work.

After that, the bank moved even more aggressively into C.D.O.’s. It added to its trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for C.D.O. traders. Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and Mr. Maheras became one of Citigroup’s most highly compensated employees, earning as much as $30 million at the peak — far more than top executives like Mr. Bushnell in the risk-management department.

In December 2005, with Citigroup diving into the C.D.O. business, Mr. Prince assured analysts that all was well at his bank.

“Anything based on human endeavor and certainly any business that involves risk-taking, you’re going to have problems from time to time,” he said. “We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability.”

Yet as the bank’s C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell — setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.

C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.

“I just think senior managers got addicted to the revenues and arrogant about the risks they were running,” said one person who worked in the C.D.O. group. “As long as you could grow revenues, you could keep your bonus growing.”

To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.

Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities.

In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Meanwhile, regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.

But he noted that what caused the largest problem for some banks was that they retained dangerously big positions in certain securities — like C.D.O.’s — rather than selling them off to other investors.

“What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets which, in turn, led to exceptionally large losses,” he said.

In fact, some analysts say they believe that the $25 billion that the federal government invested in Citigroup this fall might not be enough to stabilize it.

Others say the fact that such huge amounts have yet to steady the bank is a reflection of the severe damage caused by Citigroup’s appetites.

“They pushed to get earnings, but in doing so, they took on more risk than they probably should have if they are going to be, in the end, a bank subject to regulatory controls,” said Roy Smith, a professor at the Stern School of Business at New York University. “Safe and soundness has to be no less important than growth and profits but that was subordinated by these guys.”

photo credit: TheTruthAbout…