Cracks in the edifice


Nov 8th 2007 | NEW YORK From The Economist print edition

The world's biggest bank loses its boss, and a few billion Illustration by Satoshi Kambayashi ON REFLECTION, it was not the best of metaphors. In an interview in August, as the first wave of subprime woe was crashing over markets, Chuck Prince explained that customers flocked to Citigroup in such trying times because “we are a pillar of strength.” Less than three months later, that depiction looks almost comically awry. A double dose of mortgage-related write-downs—the first big, the second enormous—has made a mockery of risk models and controls at the world's largest bank. On November 4th, as the scale of the second write-down was revealed, Mr Prince took the “only honourable course” and resigned. The troubles of Citi and other big banks helped push down the Dow Jones Industrial Average to its lowest level since mid-September on November 7th.

It is no coincidence that Mr Prince's departure came less than a week after the ignominious exit of his counterpart at Merrill Lynch, Stan O'Neal. Both banks had ploughed gleefully into collateralised-debt obligations (CDOs), which pool mortgage-backed securities and other credit instruments, becoming the top two underwriters in the business. Poorly understood (even by their creators, it seems), these are now souring at an alarming rate.

Citi's exposure to CDOs came as a shock: it had kept $43 billion-worth on its own books. Most of this was highly rated, but so rapidly have subprime-mortgage defaults risen that even this “super-senior” paper is now being downgraded by rating agencies. In the light of this, Citi thinks it will have to take an extra hit of $8 billion-11 billion in the fourth quarter. This has filled other firms that stacked up on CDOs with trepidation (see article).

This is not an isolated slip-up for Citi, which has already had to swallow $1.4 billion of losses stemming from over-exuberance in leveraged buy-outs. It is also heavily exposed—to the tune of more than $80 billion—to some of the so-called structured investment vehicles (SIVs) that have struggled to roll over their debt in commercial-paper markets. On November 7th Moody's, a rating agency, put SIV debt, including Citi's, on review for a downgrade.

These headaches, combined with $26 billion-worth of acquisitions over the past year, have deflated the bank's capital cushion (see chart). The tier-one ratio could fall to a dangerously low 6% or less if it had to absorb and write down SIV assets, estimates CreditSights, a research firm. Citi's shares fell by 7% in a single day last week, an extraordinary drop for a bank with $2.3 trillion in assets, on fears that it would be forced to cut its dividend.

Mr Prince was struggling to get a grip on Citi long before the housing crisis. The bank was bloated, its revenues flat. Only when calls for draconian action came last year from the largest shareholder, Saudi Arabia's Prince Alwaleed bin Talal, did the streamlining take on urgency.

The mortgage mess will ensure that Mr Prince is remembered as a failure. But he deserves credit on other fronts. He pushed Citi into fast-growing emerging markets. He also invested heavily in branches and technology to bring colour to its anaemic American retail operations. Most importantly, says Dick Bove, a banking analyst with Punk Ziegel, an investment bank, he restored senior managers' faith in their ability to bring about organic growth. His predecessor, Sandy Weill, supercharged the share price with a never-ending string of bold acquisitions. But in order to find the money for those deals, Mr Weill stripped operating divisions of much-needed capital. Wall Street never quite appreciated the problems this posed for his anointed successor.

Some of Mr Prince's efforts are just starting to bear fruit. Internal growth has picked up dramatically, helped by a renewed push to channel capital to the most deserving businesses, not to the pushiest. Group revenues in the first nine months were 14% higher than a year before. “If they hadn't got their head taken off because they knew nothing about risk management in mortgages, earnings would have been impressive,” says Mr Bove.

Even so, the blow-up has rekindled worries that Citi may have grown too large and complex to manage. For all Mr Prince's efforts to bring coherence to a dysfunctional family with more than 300,000 employees in over 100 countries, synergies have proved elusive—hence the regular calls for the group to break itself up. The main operating units—global consumer, capital markets, wealth management and alternative investments—still “move to their own beat”, says one Citi banker. Mr Prince used to joke that Citi didn't have a good culture in Mr Weill's day; it had five or six. It still has at least four.

That may explain why there is hardly a stampede to apply for what should be the best job in banking. Several possible candidates seem happy to stay where they are, among them Jamie Dimon, Mr Weill's former heir-apparent. He now runs JPMorgan Chase, where he has, so far, made a better fist of creating an efficient financial conglomerate than his midtown rival. Robert Rubin, a former treasury secretary and Goldman Sachs chairman, appears to have spurned the chance, though he did agree to step in as chairman. Hence the appointment of an interim chief executive, Sir Win Bischoff, who has run Citi's European business since 2000.

The new man (or woman: Citi's wealth-management head, Sallie Krawchek, may be in the running) faces a daunting to-do list. The priority is to calm twitchy investors by showing that the bank is on top of its losses. Analysts still want to know how a pile of CDOs that warranted barely a mention a few weeks ago can now be inflicting so much damage. To be fair to Citi, transparency is improving: this week's “10-Q” filing contained previously undisclosed information about its SIVs, for instance. But Michael Mayo of Deutsche Bank worries that Citi may be entering an “information and management vacuum”: its newly installed fixed-income heads are untested, its temporary boss is an unknown quantity (in America, at least) and it is not planning to offer another financial update before mid-January.

Moreover, like other banks, it is finding that valuing its $135 billion of illiquid assets is more art than science. This week Gary Crittenden, Citi's chief financial officer, told analysts none too reassuringly that the latest valuation of CDOs was merely a “reasonable stab”. He confessed to viewing the mark-downs as no more indicative of “where we are going to come out at the end of the quarter than where we would be two weeks from now”. Further write-downs, beyond the estimated 20% haircut already taken, look probable. In a sign of how grave the problem is, Citi has picked the man who co-ordinated its role in the rescue of Long-Term Capital Management, a hedge fund that collapsed in 1998, to run its new subprime unit.

Compounding the difficulty, the new boss may have to spend much of his time fighting off legal attacks and smoothing regulators' feathers—just as Mr Prince did in his first year. Trial lawyers acting on behalf of shareholders have already taken aim at Merrill and, more recently, Citi. Meanwhile, market watchdogs are scrutinising the bank's accounting treatment of its off-balance-sheet vehicles.

Even if no further horrors are lurking in the shadows (a big if), getting Citi back on track is likely to take the best part of a year. Mr Crittenden is hopeful that its capital adequacy can be brought back to comfortable levels by mid-2008. On numerous key financial measures, including free cash flow (of over $20 billion), the bank still looks reasonably healthy. It says there is no need to cut the dividend.

But markets, twice bitten in less than a month, are understandably shy. Citi is now seven times more likely to default on its debt than it was in June, according to derivatives markets. There is even talk of the need for a white knight—perhaps a sovereign wealth fund—if Citi's mortgage losses continue to mount. If that seems far-fetched, bear in mind that so did the past week's events only a few months ago.