The two faces of Citigroup

Banks, like all businesses outside of the non-profit realm, are in the business of making money. The difference between banks and most other businesses is that banks do not create anything tangible. Of course they make tangible products possible by providing financing for companies that do actually create things, but the value in a bank resides in the intellectual capital of its workforce.
Any industry that promotes the promise of a big payday tends to attract the most clever among us, and there is no shortage of clever people on Wall Street. It is safe to say that if it is possible to squeeze a dollar out of a rock, lever it to return $100 and charge 20% for the service, Wall Street has come up with 25 ways to do it.
Auction rate securities (ARS) are one of the many inventions of Wall Street. Pitched to municipalities, port authorities, school districts and other entities that don't always grasp the full meaning of caveat emptor, they were assumed to be as "safe as cash" while providing a little extra yield. Like many things that work great until they don't, it turns out ARS aren't exactly as safe as cash.

Citigroup Leads Wall Street Drive to Hurt Taxpayers

May 9 (Bloomberg) -- Taxpayers from Massachusetts to California are paying Wall Street banks to end derivative contracts gone bad as they exit the collapsing auction-rate bond market, with penalties in some cases topping $10 million and compounding the pain of rising borrowing costs.

Sacramento County, California, paid Morgan Stanley $5 million to cancel an interest-rate swap agreement when it refinanced $79.5 million in auction-rate securities last month. The fee added to the cost of the bonds after the rate on the securities more than doubled to 9.8 percent in March as dealers stopped supporting the market.

As you may have heard, there's a home price melt down going on out there. Sacramento County is one of the hardest hit areas in the nation. This is good news for those who have been patiently saving towards a down payment on a starter home. It is not so good news for a county government with a declining tax base. Can Sacramento County really afford an extra $5million just to cancel a deal gone bad?

States, cities, hospitals and colleges face penalties exceeding $10 million to terminate swaps that failed to protect them against higher rates, according to interviews with borrowers and advisers. That's on top of the $1 billion in fees they're paying to dealers to help sell bonds that would replace auction-rate securities they sold, based on industry averages.

Citigroup, based in New York, was the top underwriter of auction-rate securities in the municipal market, arranging $55 billion in sales between 2000 and the end of last year, according to data compiled by Thomson Reuters. Zurich-based UBS AG, which said on May 6 it will close or sell its municipal bond department, underwrote $42 billion, followed by Morgan Stanley of New York at $22 billion and 19 others.

The banks are earning fees on both sides of the trade and us taxpayers are footing the bill. That's a nice hedge if you're the bank.

All this is just a drop in the bucket though:

Citigroup Plans to Shed About $400 Billion of Assets

May 9 (Bloomberg) -- Citigroup Inc. Chief Executive Officer Vikram Pandit plans to get rid of about $400 billion of assets over the next three years as he starts to whittle away at the company built by Sanford``Sandy'' Weill.

When he's done, Citigroup may cease to be the biggest U.S. bank, a title the firm has held for a decade. ``There will be more'' divestitures, Pandit told shareholders at a meeting today at the bank's New York headquarters.

The company, which lost $5.1 billion in the first quarter, has booked more than $40 billion of credit losses and writedowns since the subprime mortgage market collapsed last year. The shares dropped in New York trading today, as analysts said they were unimpressed by Pandit's proposals for returning to profitability.

What is it that causes some of the most clever people in the world to rack up such huge losses?
Besides being the most lucid resident of Berkeley, Michael Lewis, author of the famous Wall St. book Liar's Poker, remains one of my favorite columnists. He has this to say:

To both their investors and their bosses, Wall Street firms have become shockingly opaque. But the problem isn't new. It dates back at least to the early 1980s when one firm, Salomon Brothers, suddenly began to make more money than all the other firms combined. (Go look at the numbers: They're incredible.)

The profits came from financial innovation -- mainly in mortgage securities and interest-rate arbitrage. But its CEO, John Gutfreund, had only a vague idea what the bright young things dreaming up clever new securities were doing. Some of it was very smart, some of it was not so smart, but all of it was beyond his capacity to understand.

Ever since then, when extremely smart people have found extremely complicated ways to make huge sums of money, the typical Wall Street boss has seldom bothered to fully understand the matter, to challenge and question and argue.

New New Thing

This isn't because Wall Street CEOs are lazy, or stupid. It's because they are trapped. The Wall Street CEO can't interfere with the new new thing on Wall Street because the new new thing is the profit center, and the people who create it are mobile.

Anything he does to slow them down increases the risk that his most lucrative employees will quit and join another big firm, or start their own hedge fund. He isn't a boss in the conventional sense. He's a hostage of his cleverest employees.

There's an aphorism that states, "you can't cheat an honest man." It means that in order for a scheme to work, the one being solicited for the deal needs to feel like they're getting something for nothing. In the case of ARS, the purchasers thought they were getting a debt instrument as safe as cash but with a higher yield. Just as many of the most clever among us end up on Wall St, many of the not-so-clever among us end up in government, especially local government.

The late, great Milton Friedman had this to say:

There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch! Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.

So there you have it. Clever people fleecing not-so-clever people spending money that doesn't belong to them. I have a feeling that the other industry that attracts clever people in search of riches, the law industry, will make out OK in all this too.

And some believe we should have higher taxes...