Banks and hedge funds don’t mix

October 9, 2009

It was a good decision, for the wrong reason. Citigroup will sell Phibro, the energy trading business run by Andrew Hall, to avoid embarrassment over Hall’s compensation package.

Citigroup is right to rid itself of the operation, not because of pay but because federally-insured institutions have no business bankrolling hedge funds.

It’s not that Hall isn’t worth the money. According to a press release from Occidental Petroleum, which is acquiring Phibro from Citi: “from 1997 until the second quarter of 2009, Phibro averaged approximately $200 million per year in pre-tax earnings, while over the last five years Phibro’s earnings averaged $371 million per year.”

Hedge fund managers typically keep 20 percent of profits. Assuming Phibro’s earnings are reported after compensation expenses, it sounds as if the fund has been racking up $500 million in profit per year recently. A $100 million payday is in-line with what Hall would make were he operating the fund privately.

Many on Wall Street complain that Citigroup should keep the operation and give Hall his payday. Desperate to recapitalize its balance sheet, Citi is foolish to dump a profitable unit. Such concerns miss the point.

For every Andrew Hall, there’s a Ralph Cioffi and a Boaz Weinstein.

Weinstein was a wunderkind trader who made piles of money for Deutsche Bank before blowing up to the tune of $1.8 billion in 2008. Cioffi ran an internal hedge fund for Bear Stears that bet big on CDOs. He was a star while the bubble inflated, a $1.6 billion disaster when it collapsed. Before them, there was the notorious example of John Meriwether and Long-Term Capital Management, who made oodles of money before imploding and nearly bringing down most of Wall Street.

Hedge funds can be rather risky operations. Funded by thinly-capitalized federally-insured institutions, they can be lethal to the financial system. Their proprietors make big bets, often turbocharged with leverage. When they win, they take home 20 percent of profits. When they lose, they’ve lost someone else’s money.

What of the bank that stands behind the fund? What of taxpayers who stand behind the bank? With Bear Stearns, we ate $29 billion of the firm’s risky assets.

To prevent a re-run, we now stand behind all banks. This significantly reduces their cost of funds in the marketplace, funds which are still used to bankroll highly risky trading operations, internally and externally.

“Organizations that live because the government insures their liabilities shouldn’t do highly speculative things. That proposition is obvious on its face” says author Martin Mayer, who will be speaking at a conference commemorating the 10 year anniversary of the repeal of Glass-Steagall next month. “When you insure the liabilities, you have to control the assets.”

If you don’t control the assets, foolish financiers will tend to blow themselves up. In our heads-they-win-tails-we-lose banking system, this puts taxpayers in an intolerable position. Not to mention that the derivatives daisy chain means a single failure can lead to systemic failure. Yet despite today’s retreat by Citi, there’s little prospect government-backed banks will end their risky ways.

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All true, and an interesting take. The problem is the price Citi got which is apparently significantly less than one year’s profit for the unit. A great deal for Oxy, and you might even make the argument that in a round about way the feds are subsidizing Oxy’s benefit– without the taxpayers backing of Citi it wouldn’t have had to do the deal. But you’d think Pandit still could have gotten a better price.
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Posted by jjw | Report as abusive

So let’s see if we have this right. Because of political embarrassment, the government forces Citi to sell Phibro at an absurdly low price, thereby screwing Citi stockholders, a third of whom are the taxpayers, that is to say, itself.
And these are the people who are going to protect us from the forces of the evil market?

Posted by rae | Report as abusive

The gist is in the last paragraph:

“If you don’t control the assets, foolish financiers will tend to blow themselves up. In our heads-they-win-tails-we-lose banking system, this puts taxpayers in an intolerable position. Not to mention that the derivatives daisy chain means a single failure can lead to systemic failure. Yet despite today’s retreat by Citi, there’s little prospect government-backed banks will end their risky ways.”

‘Risky ways’ is considered business as usual in the finance world, even still. And this will lead to an inevitable crash. The deck is as stacked as it was in 2008 – maybe even more so. I think 2010 is going to be a very rough, rocky ride.