How Citi sank itself on the Fed’s watch
By Nicholas Dunbar The opinions expressed are his own.
Much of the financial crisis can be blamed on bankers who created complex products that allowed them to exploit and monetize less sophisticated investors, borrowers and bank shareholders. However, no account of the financial crisis is complete without an account of the inept regulators who permitted these activities to flourish, causing the crisis to become much worse than it might have been. Among these regulators, most surprising is the story of the New York Fed, supposedly the most sophisticated in its approach to risk. As I recount in this excerpt from my book, The Devil’s Derivatives and as staff at the Federal Reserve Board in Washington DC discovered, the New York Fed was in thrall to what in 2007 was the largest US bank – Citigroup – with disastrous results. -Nicholas Dunbar
The Federal Reserve may have been at the top of the U.S. regulatory pecking order, but within the Fed itself, the New York branch was top dog when it came to regulating banks. This was hardly surprising given the dual importance of Wall Street as the engine room of the bond markets and as the base for the largest multinational U.S. banks. It was only natural that industry risk-management innovations like VAR were first identified by staff in the New York Fed’s markets divi- sion, such as Peter Fisher, who transmitted the ideas to the rest of the regulatory community.
Ever since the regulatory blessing of VAR in the mid-1990s, the New York–based multinational banks had been growing rapidly. By 2003, when William McDonough retired as New York Fed president and was replaced by Timothy Geithner, an ambitious former Treasury and International Monetary Fund bureaucrat, bank supervision was equally important to markets.
If any U.S. commercial bank needed to be challenged, it was Citigroup. In 1999, when then-chief executive Sandy Weill had needed an act of Congress in order to fuse the SEC-regulated Salomon Brothers with Fed- and OCC-regulated blue-chip lender Citibank, he had taken care to reassure his new shareholders and supervisors about the importance of governance. A veteran ex-AIG and Chemical Bank executive, Petros Sabatacakis, was appointed chief risk officer of the new conglomerate and ordered to rein in the freewheeling Salomon traders. Sabatacakis was so tough in applying position limits that on the trading floor he was known as “Dr. No.”
Then came Enron and the dot-com bust. Sabatacakis may have ensured that the bank (unlike Chase Manhattan) avoided significant losses in the shakeout, but Citigroup’s conflicted role in bond underwriting, derivatives, and investment research left it open to the charge of having facilitated massive fraud at Enron and WorldCom. That led to the New York Fed and the OCC censuring the bank in July 2003, as part of a settlement in which it didn’t have to admit wrongdoing. Weill was forced to quit as chief executive (while remaining chairman).
How big banks can fix their leadership blindspots
By Katrina Pugh The opinions expressed are her own.
In the jitteriness over the stock market’s worst quarter in two years, a racing volatility index, and protests spreading across the nation’s major cities, all bank leadership (and perhaps all corporate leadership) needs to ask a fundamentally new question: “What blindspots are dogging us?” This hardly seems like a radical question. After all, most arbitrators make their money off of other people’s blindspots by seeing around corners where others can’t.
But often, leaders are unaware of blindspots in their own organizations. And they are unaware that they are unaware.
At UBS, blindspots led to $2.3 billion in undetected rogue trading losses, and the ouster of CEO Oswald Gruebel. Analysts have widely criticized UBS’s lax accountability, and oblique, easily-gamed bank systems. Corporate insider Sergio Ermotti brings a strong track record to UBS’s post of interim CEO. Entering this maelstrom, however, will put his leadership to the test.
UBS is far from alone. Many other banks have disclosed the unhappy results of ignoring blindspots, such as Bank of America’s Countrywide loan portfolio, Citibank-Japan’s clumsy disclosure process, and the French banks’ Greek loan portfolios.
We, the investors and consumers need a new cry: “These banks are too big to go stale!” They all need a good air flow. Knowledge flow, that is.
We can learn from UBS’s example. Regardless of whether Ermotti’s destiny is from interim to permanent CEO, he must start on the pathway toward greater transparency at the bank. He needs to act like an outsider in an insider’s clothing. Acting like an insider, he needs to quickly map out how knowledge has failed to reach across the vast network of traders, investment groups, and risk managers. Acting like an outsider, Ermotti needs to stride across the room and open a window. He needs to seize this moment to launch a knowledge overhaul.
I agree with the last comment that “transparency culture is obviously not what banks want to create.” Banks are kicking and screaming (privately), but publicly they are showing some readiness. Do you think these two postures will come into alignment, if they can see transparency as a sign of leadership?
Taxing spoils of the financial sector
If you want less of something, tax it.
That truism is often used as an argument against a tax on profits, or health benefits, or employment, but in the case of the rents extracted from the economy by the financial services industry here’s hoping it proves more of a promise than a threat.
The International Monetary Fund has put forward two new taxes on banks to pay the costs of future rescues, one of which is a fairly conventional “Financial Stability Contribution,” with an initial flat levy on all banks, to be refined later into something with more precise institutional and systemic risk adjustments.
More interestingly, the IMF is also proposing a “Financial Activities Tax,” (FAT) a tax on bank pay and profits which, if correctly designed, could serve as a tax on rents — the unwarranted spoils — of the financial sector.
In economics the concept of “rents”, essentially the extra money a given individual or industry is able to extract from its clients above what it would if there were perfect competition, is central. If there is only one cable television provider in your neighborhood you will know what I am talking about.
In financial services, the evidence is that rents are huge, in part because of impaired competition and in part because increasingly complex financial services allow banks to sell clients products that they don’t understand, may not need and will almost always be over-charged for. Bank employees in turn charge hefty rents to their bosses, boards and shareholders, each of whom, as you journey up the organizational chart, understand less about the complex services, and like clients, are then less able to defend their own interests.
Some of the best evidence forming the intellectual underpinning of this is provided by economists Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, whose work found that about 30 to 50 percent of the extra pay bankers get as compared to similar professionals is attributable to rents. <http://people.virginia.edu/~ar7kf/paper s/pr_rev15_submitted.pdf>
As a long in the tooth former consultant to Central Banks & Commercial Banks, here is my “old fashioned” view.
Banks are the primary engine driving the world’s economy.
Tax the Banks and they will pass it on their customers.
More expensive money means Less economic dynamism & incidentally more unproductive public service costs to regulate.
Obama must have fools for advisers.
But what do I know, it is 20 years since I was advising governments of the world.
from James Saft:
Learning from Ken Feinberg
Sometimes it's what doesn't happen that is most illuminating.
When Pay Czar Kenneth Feinberg first slashed executive compensation at U.S. firms that benefited most from a government bailout the cry was that this would hurt these weakened firms when they could least afford it, as the best and brightest would leave for better money elsewhere, where the free market still ruled.
Well, the door didn't hit them on their way out, but mostly because they stayed rooted to their desk chairs. Feinberg evaluated the compensation of 104 top executives at affected companies in 2009, reducing pay for most to levels far below financial industry norms and their own former earnings.
Yet here we are in 2010 and about 85 percent are still working for the same firms, still toiling for the kinds of wages that may well make them wish they'd gone into the law rather than finance. Remember all those articles in glossy magazines about how impossible it is to make it in New York City on $500,000 a year?
"The argument that we hear all the time; that if we don't pay more this key official will leave, he will go to a foreign competitor," Feinberg told CNBC television.
"I've always been dubious about that argument and I think the statistics bear out the fact that most officials stay at those companies."
Feinberg announced this week that he has told AIG, General Motors Co, GMAC Inc, Chrysler Group LLC and Chrysler Financial Corp to cut cash compensation for 119 top executives by a third in 2010 and total pay by 15 percent. Bank of America and Citigroup have repaid taxpayer funds and are now subject to diminished supervision by Feinberg, whose brief is to determine if pay at bailout firms is "in the public interest."
Michael Lewis’ Big Short an unsettling experience
Henry Paulson didn’t see it coming. Nor did Timothy Geithner foresee the meltdown of the financial markets. According to Standard & Poor’s President Deven Sharma, testifying before Congress in the fall of 2008: “Virtually no one – be they homeowners, financial institutions, ratings agencies, regulators, or investors – anticipated what is occurring.”
Why? Perhaps “it took a certain kind of person to see the ugly facts and react to them – to discern, in the profile of the beautiful young lady, the face of an old witch,” says Michael Lewis, author of numerous best-sellers including 1980s Wall Street memoir Liar’s Poker and now The Big Short: Inside the Doomsday Machine (W.W. Norton, $27.95).
Lewis’ new volume is an entertaining and very edifying look at several such insightful people — the tiny handful of investors “for whom the trade became an obsession.” These were unusual, “almost by definition odd” folks, soon to make big money on the cataclysm: There is Steve Eisman, the former Oppenheimer analyst who regularly demonstrated a prodigious “talent for offending people,” notably in a tendency to trash subprime originators as early as 1997.
Next up is Michael Burry, a compulsive, “one-eyed money manager,” a man profoundly uncomfortable around other people who could only work alone in his office with the door closed and the shades drawn. Poring over obscure corporate documents, Burry saw the insanity in the financial markets and in 2005 began prodding big Wall Street firms to offer credit default swaps, or financial insurance policies, against the failure of mortgage-backed derivatives. Finally, there’s the “weirdly like-minded” threesome who made up the money-management outfit they called Cornwall Capital Management. They were “sweet-natured, disorganized, inquisitive” –”the kind of guys who might turn up at their fifteenth high school reunions with surprising facial hair and a complicated life story.”
This band-of-outsiders conceit is familiar — reminiscent of everything from Huckleberry Finn to The Dirty Dozen – and if The Big Short were no more than a collection of such profiles, it would satisfy many readers. But Lewis’ volume has lots more to offer thanks to its clear explication of exotic derivatives and meltdown events.
Much of this may be familiar to regular readers of the financial press, and may remind some of Wall Street Journal writer Gregory Zuckerman’s much lauded account of hedge-fund trader John Paulson’s $15 billion coup, The Greatest Trade Ever. But even these readers are likely to admire the lucidity of Lewis’ book. Here, for example, is how Lewis explains the two financial instruments at the heart of the mess. The subprime mortgage-bond-backed collateralized debt obligation, or CDO, was “so opaque and complex that it would remain forever misunderstood by investors and rating agencies.”
It was a bunch of mortgage bonds, often rated triple-B, used to construct an entirely new tower of bonds, which ratings firms like Moody’s and Standard & Poor’s were persuaded to rate triple-A. The CDO, which hid huge risks via obfuscation, “was a machine that turned lead into gold” for Wall Street, writes Lewis. The credit default swap, meanwhile, was effectively an insurance policy with semiannual premium payments – but also an asymmetric bet. As in roulette, “the most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money.”
Anyone know how to get in touch with Cornwall Capital? I’m really impressed by their methods and I’m looking into establishing my own derivative based hedgefund.
Easier jawboning banks than leery borrowers
(James Saft is a Reuters columnist. The opinions expressed are his own)
Jawbone all you like, but we are in a private sector de-leveraging, and bank lending and demand will remain weak, making interest rates unlikely to rise any time soon.
Monday’s two big economic news events dovetailed neatly, if not entirely happily; Citigroup announced plans to repay $20 billion to the government and President Obama called banks together to inform them of their obligation to support the recovery.
“My main message in today’s meeting was very simple: America’s banks received extraordinary assistance from American taxpayers to rebuild their industry,” Obama said after the meeting. “Now that they’re back on their feet, we expect an extraordinary commitment from them to help rebuild our economy.”
I just don’t think that is how it is going to work, or really how the capital intermediation process has ever worked. Banks will make loans when they have sufficient capital, when there are good opportunities, meaning demand for loans from good risks willing to pay good rates, and when there aren’t better opportunities elsewhere.
Taking one for the team is not how shareholder capitalism works, even if you lavish upon it public money.
Citigroup and the other 50-odd institutions which have repaid TARP funds have good reason to want to pay back the money — it makes them look weak to clients and investors and ties their hands when it comes to compensation. It is also quite unnecessary to have direct government money because there is so much of the indirect kind. Washington let it be known in the spring that the largest banks wouldn’t be allowed to fail, effectively underwriting their financing via that guarantee.
from Commentaries:
Giving props to Wall Street’s risks
Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors -- maybe even you and me.
Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading -- bets made for a bank's own behalf -- is really just a small part of their business.
Lately, Wall Street's captains of capitalism have been aggressive in pushing the "we take big risks for our customers, not for ourselves" line of argument.
That's especially so in the wake of the public furor over the outsized trading gains at the big banks like Goldman Sachs Group, JPMorgan Chase and Barclays and even Citigroup, so soon after the collapse of Lehman Brothers.
The notion that risk is being taken for customers as opposed to for the firm's own benefit is somehow supposed to make it seem more palatable and somehow less risky.
Still, for many, the image persists that investment banks spend a lot of time and resources gambling on stocks, bonds, commodities or currencies to generate fat profits and big bonuses. And there's good reason for that image: Wall Street firms don't break out the dollars they take in from client trades versus those generated by prop trading.
Yet from the perspective of Wall Street bankers, it's perfectly logical to see much of their risk taking simply as part of trades for their customers.
There is no denial that banks take risks for the investors.The important point is that the risks must be manageable even if the investments go bad & should not lead to making the very institution bankrupt like Lehman Brothers seeking taxpayers money to rescue them or vanish.Do the same very banks when in good times pass on surplus money to the state treasury instead of frittering it away illogically high salary,perks & bonuses to their executives? Why the banks don’t find inbuilt provisions to withstand such critical situations without asking for state crutches?
from Commentaries:
Time to get tough with AIG
It's time for someone in the Obama administration to read the riot act to Robert Benmosche, American International Group's new $7 million chief executive.
Since getting the job, Benmosche has spent more time at his lavish Croatian villa on the Adriatic coast than at the troubled insurer's corporate offices in New York.
And in the short term, Benmosche's vacation strategy appears to be paying dividends.
This week, AIG's shares surged 44 percent, to nearly $50, after Benmosche said that he intended to move slower than his predecessor in selling off AIG's still viable divisions.
Maybe Benmosche should consider relocating AIG's headquarters to Dubrovnik.
But the big run-up in AIG shares is merely a sideshow for momentum players, speculators and Hank Greenberg, the former AIG chieftain who controls about 11 percent of the company's outstanding shares.
The reality is that AIG exists today only because of the $180 billion lifeline the insurer has received from the federal government. Even Benmosche acknowledges that, telling The Wall Street Journal: "If the U.S. government doesn't continue to support AIG, we will fail."
They should have changed the whole management team right away, and appoint a new team to restructure the whole company.
from Commentaries:
Citi’s dirty pool of assets
Hard as it may be to believe, shares of beleaguered Citigroup are on fire.
The stock of the de facto U.S. government-owned bank is up some 300 percent after it cratered at around $1 back in early March.
The over-caffeinated stock maven Jim Cramer keeps calling Citi a "buy, buy, buy" on his nightly CNBC television show. Even the more sober-minded writers at Barron's are pounding the table a bit, predicting Citi shares could double in price in three years."
Time out! It's far too soon for anyone but stock flippers and fast money hedge funds to buy Citi right now.
That's because there's still a world of hurt for Citi in the $83.2 billion in subprime mortgage-backed securities, corporate loans, home loans and commercial real estate mortgages that the bank's finance team has stuffed neatly into something called the "Special Asset Pool."
But there's nothing special at all about these assets. This cesspool of toxic securities and floundering loans is the worst of the stuff that's been stinking up Citi's balance sheet.
And these rotting securities and loans represent a good chunk of the $300 billion in problem assets the federal government is guaranteeing under its bailout of the giant bank.
The rules have changed at least temporarily and when it’s time, they’ll change them back. But right now there are stocks with unbelievably low P/E’s and likewise high EPS numbers that are just sitting there waiting so what good does it do you to wait on them and miss this? These times are hard for the traditional numbers guys because it’s name recognition, hope and speculation time. AIG?
Stress tests: The results are in, now what?
– Mark T. Williams, who teaches finance at Boston University’s School of Management, is a former Federal Reserve bank examiner. The views expressed are his own. –
The market has anxiously waited over two months. With the stress test results in, we now have our work cut out for us. Not that these findings were surprising, as the 10 banks which made the government’s “need to raise additional capital now” list are the usual suspects, such as Bank of America (BofA), Citigroup, Wells Fargo, SunTrust, Fifth Third, KeyCorp, and Capital One. They were problem banks before the tests and they continue to be. But this painfully drawn-out process has spawned four tangible benefits worth discussing.
First, the stress test results raise an important policy question: Should our largest banks, those central to our economy, be allowed to take such large risks? These results paint a clearer picture of the level of risky lending practices that many of our 19 largest banks engaged in over the last decade. The government’s assessment provides added support to the need for re-regulation in this vital industry. In the worst-case scenario, the Fed reported that these banks, which control the majority of our country’s deposits and loans, could need to raise approximately $600 billion in additional capital just to cover increased loan defaults.
Second, the stress test results show that risky bets were not just concentrated but spread over many areas, including trading and financial contracts, first and second mortgages, commercial loans, securities, and credit cards. Having more detail on the sheer scope and size of these risky bets and potential losses provides a stronger case for the need to revamp the capital standards currently applied to banks.
It also raises the question of how the Fed and other regulators might monitor the on-going level of bank risk-taking activities. Under the existing Tier 1 regulatory capital standard, almost all 19 banks pass with flying colors, yet the stress tests show a bleaker picture as the majority failed this equally important financial health test. The level of risk they are taking, should the economy weaken further, can not be supported by their current level of capital. Tests indicate that the 10 weaker banks need to raise approximately $75 billion to cushion against those losses.
Going forward, higher regulatory capital standards should be mandated. Banks also should be discouraged from risky lending practices, and a new Glass-Steagall type act, which was unfortunately repealed in 1999, needs to be put back on the table. Doing so will help to separate higher risk-taking banks from lower risk-taking banks.
Third, the stress test results highlight the fragility of our banking industry and the need for bankers to rethink what are acceptable levels of risk taking. Not long ago, the term “stodgy” was used to describe a bank or banker. Today it’s more accurate to use “risky.”
Just one thing more should happen after your points.
Banker’s income should be decoupled from share value and company’s profits. The remodelling of their income not fully connetced to equity stakes and involved interests, should/could help, in addition to your 4 point remarks, to refocus on recalibrated risk-taking.
OCC is not a regulator