Citigroup ‘Liquidity Puts’ Draw Scrutiny From Crisis Inquiry
By Bradley Keoun, Jesse Westbrook and Ian Katz
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.”
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