Citigroup: Portrait of Why Too Big Has Failed

By Pam Martens: November 21, 2012 

As we reported in August, the law firm Kirby McInerney agreed to settle a lawsuit against Citigroup on behalf of shareholders for $590 million over allegations that the firm issued materially false and misleading statements concerning Citigroup’s exposure to losses from collateralized debt obligations and other off-balance-sheet accounting tricks.

A careful reading of the 547-page amended complaint reveals a major U.S. financial institution that used every contrivance imaginable to inflate its earnings by gaming the system with high risk leverage, off-balance-sheet gambles it inevitably lost and dysfunctional checks and balances — all while its regulators were asleep at the switch.

The deeply researched document, unfortunately, leaves serious questions unanswered: where were the company’s auditors during all of these machinations?  Who were the lawyers writing the prospectuses for these dodgy assets? How did Citigroup’s two chief regulators, the New York Fed and the Office of the Controller of the Currency, fail to rein in the myriad financial abuses that left the company teetering and needing a large-scale government bailout? And, most importantly, where are the criminal prosecutions by the Department of Justice?

Below are some of the most disturbing aspects of how this too-big-to-fail institution conducted its business:

Collateralized Debt Obligations (CDOs) 

CDOs operate as offshore limited liability companies.  There is no public reporting as to their asset holdings. This information is provided only to actual and potential CDO investors, through password-protected websites. Unknown to the investing public or its shareholders, Citigroup had been unable to sell the super senior tranches of the subprime CDOs it underwrote. They accumulated, both on and off Citigroup’s books, to the staggering sum of $55 billion.

Citigroup’s losses eventually ran in excess of $30 billion on subprime CDOs.

“As plaintiffs’ investigation of Citigroup’s subprime CDOs demonstrates, Citigroup’s 2004-2007 subprime CDOs produced tens of billions of dollars of super senior tranches – and, effectively, Citigroup never sold (except with its money-back guarantees) a single one. The essence of an underwriter’s function is to sell the securities it underwrites. Citigroup’s inability/failure to accomplish any such sales was an alarming but unheeded red flag as to the value and liquidity of these instruments. The difficulty in selling these super senior tranches was of Citigroup’s own making: it had stripped yield from these super seniors in order to make the junior tranches more marketable. These super seniors thus became, effectively, all risk and no reward.”

During 2004 and 2005, Citigroup sold $25 billion of CDO commercial paper super senior tranches with a guarantee to repurchase them all, at full price, if collateral concerns ever disrupted the rollover of the commercial paper. In addition to a fee of $375 million for the underwriting, it received $50 million annually for that money-back guarantee.  This permitted Citigroup to hide its exposure off its books while boosting revenues by $50 million a year.

Citigroup, in order to accelerate its cash-cow CDO underwriting business, “silently swallowed tens of billions of dollars of the super senior tranches that business produced.”  It had an insider’s window into the risk it was hiding off its balance sheet and a full appreciation that it was manufacturing product for which there was no buyer but itself. 

Structured Investment Vehicles (SIVs)

Citigroup created seven off-balance-sheet Structured Investment Vehicles (SIVs), totaling $100 billion.  Citigroup used “Enron-like accounting” to disclaim any exposure to the SIVs which did not appear in its public financial statements.  This allowed the firm to avoid capital charges and reserves while enjoying income of at least $100 million per year from the SIVs.

“In November and December 2007, Citigroup admitted that the purported ‘off balance sheet’ aspect of its SIVS was and had always been a fiction. With the stroke of a pen, approximately $50 billion of SIV liabilities (and the lesser value of the impaired assets purportedly collateralizing those liabilities) were transferred from ‘off’ Citigroup’s balance sheet to ‘on.’ Once there, they immediately degraded it. Citigroup’s capitalization was further weakened, its credit ratings were cut immediately, and billions of dollars of write-downs ensued.” 

Citigroup’s share price collapsed into the low single digits.

Collateralized Loan Obligations (CLOs)

These were loans to lower credit rated companies that were then pooled together.

“After purchasing insurance on a CLO tranche, Citigroup would book the difference in the cost of the insurance and the payments of the loan for the entire life of the loan immediately as if the loan had been sold…Additionally, Citigroup engaged in negative basis trades with the billions of dollars of CLO exposure remaining on the Company’s balance sheet. These trades allowed Citigroup to book immediate gain for the entire term of loans by purchasing insurance on their default and, thereby, treat the purchase of insurance as a sale of the loans when, in fact, those loans (or rather, those CLO tranches) never left Citigroup’s books…In addition to the high fees for CLO creation, the ability to create instant gain through these trades was a powerful incentive for Citigroup to issue ever riskier leveraged loans. While revenue from fees and negative-basis trades inflated Citigroup’s earnings on leveraged loans and CLOs, Citigroup kept its shareholders unaware of the artificial source of the gains or the inherent risks in continuing to operate its ephemeral money-making machine.”

In its October 1, 2007 filing with the SEC, Citigroup finally announced its extensive CLO exposure.  It said it was taking a write-down of $1.4 billion on its “highly leveraged finance commitments” and that “these commitments totaled $69 billion at the end of the second quarter and $57 billion at the end of the third quarter.”

Sandy Weill, the Chairman and CEO who was at the helm of Citigroup when the CDO funny-money game took place, left the firm a billionaire from outrageously obscene compensation; Robert Rubin, a former member of the Board, received Citigroup compensation in excess of $120 million; former CEOs Chuck Prince and Vikram Pandit left as multi-millionaires.

This $590 million settlement estimates that shareholders who make a claim might expect to receive 19 cents a share if all shareholders during the class period make claims. Long-term shareholders have lost 90 percent of their investment in Citigroup common stock in the past five years.  That 19 cents is not going to heal many wounds but there is at least a 547 page public document finally available to educate Congress on the work that remains to reform Wall Street.

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