The U.S. panel probing the
financial crisis has zeroed in on Citigroup Inc. guarantees used
to spur sales of mortgage-backed debt that ended up costing the
bank $14 billion.
Financial Crisis Inquiry Commission investigators may
conclude a primary cause of Citigroup’s 2008 bailout was the use
of “liquidity puts” by traders to bolster sales, Chairman Phil
Angelides said in an interview yesterday. Those puts allowed
customers to sell debt securities back to the bank at face value
if credit markets froze, something that Citigroup’s traders bet
would never happen, according to Angelides.
Instead, Citigroup was forced to buy back $25 billion of
collateralized debt obligations now valued at 33 cents on the
dollar as financial markets broke down in 2007, according to the
New York-based bank’s statements. The same kind of flawed logic
pushed American International Group Inc. to the brink of
bankruptcy in 2008 after insuring billions of dollars of CDOs
against default, Angelides said.
“Institutions across a broad band were guaranteeing risks
that they did not understand,” Angelides said. In Citigroup’s
case, “they clearly got it wrong.”
Chief Executive Officer Charles O. “Chuck” Prince,
Executive Committee Chairman Robert Rubin and regulators
testified before the commission last week they didn’t know about
risks posed by the instruments. The bank’s annual report for
2003 -- signed by Prince and posted on the Securities and
Exchange Commission’s Web site in early 2004 -- disclosed the
risk of “contingent liquidity facilities” tied to CDOs.
Concentration Risk
Citigroup kept its liquidity puts in place even after the
bank’s own financial-control group wrote a memo in October 2006
saying they might lead to a “severe concentration risk,” based
on excerpts of the memo read by Angelides during an April 7
hearing.
“It certainly looks bad,” said Andrew Davidson, president
of New York-based Andrew Davidson & Co., which advises investors
on the mortgage market and asset-backed securities. “The fact
that they didn’t know that they had this exposure, that’s
obviously screwed up.” Citigroup spokesman Steve Cohen declined
to comment.
The CDO business generated $400 million in “total annual
revenue in 2005 and 2006,” Nestor Dominguez, co-leader of the
unit, testified at hearings last week. The revenue included fees
from setting up the deals as well as profit from trading them,
he said.
A liquidity put allows investors to “put back” their
securities to the issuing bank under certain conditions. In
Citigroup’s case, the guarantees were tied to CDOs created by
the bank that pooled mortgage-backed bonds, corporate debt and
other securities, Dominguez testified.
Commercial Paper
To raise money to buy the assets, Citigroup sold commercial
paper, with the assets pledged as collateral. Commercial paper
is a type of debt that matures in less than a year and was
popular with money-market funds and corporate treasurers who
want to invest their surplus cash in readily redeemable funds
while earning higher yields.
Liquidity puts were added to “facilitate” the sales of
the commercial paper, Dominguez said; investors could “put
back” the commercial paper to Citigroup if the market went
cold. Dominguez described this as a “significant widening in
credit spreads or a temporary inability to issue commercial
paper.” Widening credit spreads, or the gap between a bond’s
yield and benchmark rates, indicate slackening investor demand.
Remote Risk
Citigroup’s traders viewed the risk that anyone would use
the puts as remote and didn’t notify senior executives,
according to testimony at the hearings. Since the risk was
considered so unlikely, the bank kept the puts off its balance
sheet, and held little capital to cover any costs that might
arise, commission member Byron Georgiou said at the hearings.
While the CDOs weren’t included among the bank’s
$2 trillion of assets, they were mentioned in footnotes
detailing off-balance-sheet commitments, Citigroup’s financial
statements show.
Transactions designed to move assets and potential risks
off the balance sheet may have masked billions of dollars of
risks at Lehman Brothers Holdings Inc. before its collapse,
according to a report last month by a bankruptcy examiner.
Citigroup is getting extra attention from the FCIC panel
because it got a $45 billion emergency infusion and $301 billion
of government asset insurance. That represented the biggest
taxpayer bailout for a U.S. bank. Citigroup repaid $20 billion
of the funds in December and canceled the insurance. The U.S.
retains a 27 percent stake in the bank.
Hearings
The FCIC’s commissioners used hearings last week in
Washington to delve into Citigroup’s liquidity puts, calling
Prince and Rubin as witnesses along with former Federal Reserve
Chairman Alan Greenspan and Comptroller of the Currency John
Dugan.
The risk of the CDOs and the liquidity puts “came as a
surprise” to the OCC, Dugan said at the April 8 hearing, adding
that “subsequent review and investigation showed this to be
both a risk management and an internal reporting breakdown by
the company.”
The liquidity puts, backed by the Citibank banking unit,
were insulated from close examination by Dugan’s Office of the
Comptroller of the Currency, according to Georgiou. That’s
because the puts were created by Citigroup’s investment bankers,
which operated in Citigroup’s non-deposit-taking securities
unit, Georgiou said during last week’s hearings.
No Authority
“The OCC examiners that we talked to suggested to us that
they regarded these liquidity puts as essentially outside of
their purview, because they were only supposed to be looking at
the, you know, this was a principal business that was existing
within the investment bank,” Georgiou said. “Not only wasn’t
it their responsibly, they were effectively precluded from
examining it.”
Greenspan told the panel April 7 that regulators probably
should have scrutinized the bank’s liquidity puts along with its
loans and other assets. The Federal Reserve oversees Citigroup’s
holding company.
“You’re raising a legitimate question,” Greenspan said.
Citigroup used the liquidity puts partly because they
required less capital support than backup credit lines that
banks typically offer, Georgiou said.
The liquidity puts were subject to a 0.8 percent capital
charge, Georgiou said. Put another way, the bank had to set
aside $1 of capital for every $125 of commercial paper. That
compares with Citigroup’s overall ratio of $1 for every $14.50
of loans, securities and other investments as of Dec. 31.
“Would the team create products and in the course of
creating the products try to minimize capital burdens?” Prince
said during his testimony. “My guess is the answer is yes, but
I don’t know for sure.”
Angelides said at the hearings that Prince and Rubin failed
to take responsibility for what happened at Citigroup.
“One thing that is striking is the extent to which senior
management either didn’t know or didn’t care to know about risks
that ultimately helped bring the institution to its knees,”
Angelides said in this week’s interview. “If you’re having to
offer buyers a put back to you, that should be a big red flag.”
To contact the reporters on this story:
Bradley Keoun in New York at
bkeoun@bloomberg.net;
Jesse Westbrook in Washington at
jwestbrook1@bloomberg.net;
rschmidt5@bloomberg.net;
Ian Katz in Washington at
ikatz2@bloomberg.net.
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