The Citigroup of the past decade is THE shining example of an array of costly failures: accounting policies; business strategies; management compensation schemes; risk management practices; and Government policies. And now we see that Citigroup is doing badly; more badly, in fact, than many thought likely. Rubin is out. Smith Barney is being jettisoned for a little cash and some accounting profits. Desperation is taking hold. Will more bailout funds be required, notwithstanding the egregious deal the second-time around? You can bet on it. We are now seeing the sequel to the original Citigroup drama, As the Stomach Turns.
First, there was the Sandy Weill empire-building phase. In short, accounting standards gone awry. Because of the “pooling method” of accounting for mergers, Sandy was able to bolt on enterprise after enterprise by doing stock deals that met the necessary criteria. This resulted in effectively slapping together two sets of historical financial statements without showing the “goodwill” (premium paid over tangible book value) paid for in the deal. And because there were no charges to earnings for the amortization of goodwill, Citigroup could defer the time when it needed to come clean that it had paid too much for acquisitions and that the goodwill didn’t really exist. Happy for Sandy, his largest deals (Primerica/Travelers and Travelers/Citicorp) were done prior to the end of the pooling method pursuant to FAS 141 and 142. Surprise, common shareholders! We paid tens of billions too much for the businesses we bought. But the joke is on you. To even greater effect, Citigroup availed itself of a juicy 21st century accounting fiction, Special Purpose Vehicle (SPV) accounting, that laid the foundation for its cataclysmic collapse over the past 18 months.
Sandy figured out something truly brilliant: by growing so large he created a firm that was “too big to fail,” but just big enough to get paid outsized sums for facilitating its growth-by-acquisition strategy. Get paid on the upside and bailed out on the downside. Whether it was simple greed or an amalgam of greed and market prescience, his strategy worked beautifully. He got paid princely sums while the firm was in rapid growth mode and got out near the top, his minions – and the US taxpayer – were left to deal with the detritus after-the-fact. This may have been his most brilliant business deal of all; working with his Board to get paid for high-risk, ultimtely transient earnings and bailing out at just the right time. Has anybody showed such skill at market timing? Nice work, Sandy. Further, his approach was also deeply flawed from a corporate finance perspective. With few realizable synergies among his portfolio of businesses, it would have been more efficient and created greater shareholder value by having these businesses as stand-alone entities. They would be been more focused, properly financed, received the necessary managerial oversight and attracted the best investors for their particular business activity. Asset allocation is always done best at the investor level; corporate managers only have an incentive to get big, and the friction and distraction associated with managing a disparate array of businesses is costly for both shareholders and the businesses alike.
Grow the numerator (revenues), avoid charges to the denominator (goodwill), take more risk and back up the compensation truck at year-end. It really wasn’t that complicated. Conglomerators for decades have played a similar game and made away with monstrous rewards for their era. It is only that so much had been written about pooling and its being an accounting fiction that Boards and HR departments should have been hip to the game by the late 1990s. This, together for paying for short-term results, particularly in its trading businesses, contributed to a compensation culture that was skewed towards all the wrong things – top line growth without an approriate discount for risk and persistence. Not smart, guys.
Risk Management Practices
When the intellectual purity of Jamie Dimon was still at hand, he sharply reduced Citigroup’s exposure to Russia – and fast. He closed down the Risk Arbitrage group at Salomon. He was laser-focused on the risk side of the equation. Once he left, nobody stepped in to fill the void (except that LTCM guy). It decided to crank up the securitization machine and to play accounting gimmickry, circa 2004: the SPV game. It pushed hundreds of billions of dollars of CDO exposure off-balance sheet, meeting the accounting critieria for de-consolidation while retaining enough risk to have the assets come flying back onto its books if certain “unlikely” things happened. Well, they did and they did, and these SPVs, which enabled Citigroup to present financial statements and footnotes that drastically understated its real exposure, were the key contributor to its undoing. While this was certainly an accounting game, it was also a severe breakdown in risk controls because regardless of where these assets were housed, Citigroup retained real economic exposure to their performance. And Citigroups risk management team, without question, fell down when it came to taking these SPV risks into account.
While Sandy set the table, Hank and Friends have been trying to clean it up, without much success. First a $25 billion injection, no strings attached. Then a massive backstop deal whose cost is currently unknown, but is many multiples of the original staggeringly large cash injection. Yet the problems still remain. Why? Because the Treasury has been reluctant, for some reason, to get tough with Citigroup’s management and to clean house once and for all. Take over the firm. Employ a good bank/bad bank strategy. Force mark-to-market accounting across the banking sector and see exactly which institutions are the walking dead, which are broken but can be repaired and which are a.o.k. Develop a consistent plan. Execute the plan. Stop with the one-off, band-aid solutions. Citigroup needs a redo, just like the auto industry. And just like Social Security. Wipe out common and junior debt holders. Sell off good assets to the private sector or spin them off. Warehouse bad assets and work them out over time. But Sandy was right; shareholders and the Government permitted Citigroup to become too big to fail. Well, it needs to fail. Just not in the haphazard, destructive way that Lehman failed. It can be done much, much better.
Someone needs to take Citigroup out behind the barn and shoot it. Because if we don’t, it just may kill us in the process.