This week’s Atlantic column is my somewhat belated response to Judge Jed Rakoff’s latest SEC takedown, this time rejecting a proposed settlement with Citigroup over a CDO-squared that the bank’s structuring desk created solely so that its trading desk could short it. I think Rakoff has identified the heart of the issue (the SEC’s settlements are unlikely to change bank behavior, so what’s the point?) but he’s really pointing to a problem that someone else is going to have to fix: we need either a stronger SEC or stronger laws. I’d like to see an aggressive, powerful SEC that can deter banks from breaking the law, but we don’t have one now.

Earlier this week, Richard Fisher – President of the Dallas Federal Reserve Bank – captured the growing political mood with regard to very large banks:  “I believe that too-big-to-fail banks are too-dangerous-to-permit.” Market-forces don’t work with the biggest banks at their current sizes; they have great political power and receive almost unlimited implicit subsidies in the form of protection against downside risks – particularly in situations like now, with the European financial situation looking precarious.

“Downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then, creative destruction can work its wonders in the financial sector, just as it does elsewhere in our economy.”

Mr. Fisher is an experienced public official – and also someone with a great deal of experience in financial markets, including running his own funds-management firm.  I increasingly meet leading figures in the financial sector who share Mr. Fisher’s views, at least in private.

What then is the case in favor of keeping mega-banks at their current scale?  Vague claims are sometimes made, but there is very little hard evidence and often a lack of candor on that side of the argument.  So it is refreshing to see Vikram Pandit, CEO of Citigroup, go on the record with The Banker magazine to at least explain how his bank will generate shareholder value.  (The interview is behind a paywall, unfortunately).

Citi is one of the world’s largest banks.  According to The Banker database, which uses data from the end of 2010, it had total assets of just under $2 trillion – putting it in the top ten worldwide.  Overall, The Banker ranks it as number four in its “Top 1000 World Ranking”.  Citi is also #39 on the Forbes top 500 global companies list, with total employment of 260,000.

Is there indication in Mr. Pandit’s vision that mega-banking will be good for the rest of us in the future?  Don’t look for Citi to drive any kind of rethinking for the US consumer market – Mr. Pandit wants out: “We made a similar decision that we were too large in the US consumer finance business and to downsize.”

The engines of growth, according to Mr. Pandit, will be “the global transactions services business” and “emerging markets.”

Transaction services are important but they do not require a very large balance sheet – these can equally well be performed by a network of small, nimble financial firms.  Global commerce existed for centuries before banks built up risks that are large relative to their home economies.

And emerging markets are risky – Mr. Pandit is essentially betting that Citi can ride the cycle in those countries.  Probably there will be relatively good profits for a number of years and this will justify high compensation levels.  But when the cycle turns against emerging markets – as it did in 1982 – what happens?

In 1982, Citi had a large loan exposure to the emerging markets of the day, Latin America, communist Poland and communist Romania; it was saved from insolvency by “regulatory forbearance,” meaning that the Federal Reserve and other regulators did not force them to recognize their losses.  Citi was a relatively big bank at that time – but it was much smaller than it is today.

And its complex global operations are exactly what would make it very hard to “resolve” or put through orderly liquidation under Dodd-Frank.  I argued here in March that there is no meaningful resolution authority for global banks; before and after that column I’ve taken this point up in private with senior officials in the US and Europe responsible for handling the potential failure of such entities.  No one disagrees with my main point – we cannot handle the collapse of a bank like Citigroup in “orderly” fashion.

Jon Huntsman put megabanks on the agenda for the Republican primaries, with a blistering op ed in the Wall Street Journal a few weeks ago: Too Big to Fail is Simply Too Big.

Other contenders for the Republican nomination have followed his lead, including most recently Newt Gingrich.  Whoever ends up going head-to-head with Mitt Romney is likely to make good use of this very theme – because Mr. Romney already has so much financial support from the top of Wall Street, it will be very hard for him to respond effectively.

Breaking-up the biggest banks is not a fringe idea to be brushed off; Mr. Fisher is speaking for many people who work in financial services – the big banks are not good for the rest of us.  Mr. Pandit’s interview just reinforces this point.

Any Republican candidate who claims to be fiscally responsible must eventually confront the issue – what was the role of big banks in the enormous recession and consequent massive loss of tax revenue since 2008?  Which sector poses clear and immediate danger to our fiscal accounts, looking forward – and in a way that is not yet scored properly in any budget assessment?  As Mr. Fisher put it, rather graphically,

“Perhaps the financial equivalent of irreversible lap-band or gastric bypass surgery is the only way to treat the pathology of financial obesity, contain the relentless expansion of these banks and downsize them to manageable proportions.”

I suggest that Mr. Fisher could reasonably begin with Citigroup.

An edited version of this post appeared on the NYT.com’s Economix blog this morning; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Vikram Pandit heads Citigroup, one of the world’s largest and most powerful banks.  Writing in the Financial Times Thursday morning, with regard to the higher capital standards proposed by the Basel III process, he claims

“There is a point beyond which more is not necessarily better. Hiking capital and liquidity requirements further could have significant negative impact on the banking system, on consumers and on the economy.”

Mr. Pandit is completely wrong.  To understand this, look at the letter published in the Financial Times earlier this week by finance experts from top universities – the kind of people who trained Mr. Pandit and his generation of bank executives.

The professors write,

“Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.”

The point is that “bank capital” just reflects the choice between debt and equity – to “have more capital” simply means to rely more on equity relative to finance.  From the professors again, and remembering that these people also have a great deal of practical experience,

“High leverage encourages excessive risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk taking at the expense of creditors or governments.”

“Bankers warn that increased equity requirements would restrict lending and impede growth. These warnings are misplaced. First, it is easier for better-capitalized banks, with fewer prior debt commitments hanging over them, to raise funds for new loans. Second, removing biases created by the current risk-weighting system that favor marketable securities would increase banks’ incentives to fund traditional loans. Third, the recent subprime-mortgage experience shows that some lending can be bad for welfare and growth. Lending decisions would be improved by higher and more appropriate equity requirements.”

Mr. Pandit is a smart individual and he knows all this – he has a Ph.D. in finance from Columbia University.  Why then does he advance such obviously specious arguments in the pages of the Financial Times?

The answer is straightforward.

a)      He can get away with it.  Modern financial CEOs float in a cloud above the public discourse; they can spout nonsense without fear of being contradicted directly in the pages of a leading newspaper.

b)      Officials listen to bank CEOs and an op ed gets their attention.  Perhaps they think Mr. Pandit knows what he is talking about – or perhaps they know that these arguments are completely specious.  In any case, they are deferential.

c)      Mr. Pandit is communicating with other CEOs and, in this fashion, encouraging them to take recalcitrant positions.  There is an important element of collusion in their attempts to capture the minds of regulators, politicians, and readers of the financial press.

Mr. Pandit is engaged in lobbying, pure and simple.  Ask the people who invented modern finance theory and figured out how it should be applied (second to last paragraph),

“Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks’ shareholders and managers, with taxpayers picking up losses and economies suffering the fallout.”

I’ve already criticized Citigroup CEO Vikram Pandit’s testimony before the TARP Congressional Oversight Panel on Thursday, but there’s one thing I left out. Citigroup, like other banks not named Goldman Sachs, is attempting to cloak itself in a mantle of goodness. Pandit’s testimony included several bullet points discussing all the wonderful things that Citigroup is doing for ordinary Americans. For example: “In 2009, we provided $439.8 billion of new credit in the U.S., including approximately $80.5 billion in new mortgages and $80.1 billion in new credit card lending.”

There are two problems with these kinds of numbers. One is that I have no idea what to compare them to. I looked through Citigroup’s most recent financial supplement and was unable to find any numbers for “new credit,” let alone those numbers in particular. For a credit card, what does “new credit” mean? If I have no balance, and then I lose my job so I run up $20,000 on my Citi credit card, is that $20,000 in new credit? Or does new credit only include new cards issued? If so, how does it compare to credit taken away by closing people’s accounts or reducing their credit limits?

The second is that whatever Pandit says about “new credit,” it’s hard to argue that credit didn’t contract in 2009. For example, total consumer loans (p. 27) fell from $484 billion at the end of 2008 to $443 billion at the end of 2009, and total corporate loans fell from $218 billion to $177 billion, while money deposited with other banks (including the Federal Reserve) grew by $100 billion. Now, this is not all Citigroup’s fault. For one thing, they were overextended, so de-leveraging made sense from a balance sheet perspective, and for another there may have been a decline in demand for credit. But I’m still troubled by this attempt to pretend that Citi was fueling the economic recovery by stepping up lending.

Update: A friend who I believe has plenty of credit and no need for more writes in to say that the credit line on her Citibank credit card was just increased by $6,000, even though she never used more than one-third of her old credit line. She was wondering why until she realized that the $6,000 counts as “new credit” to Citi.

More importantly, Pandit said that Citigroup is on the side of the angels — in this case, the side of real financial reform:

“Citi supports prudent and effective reform of the financial regulatory system. America – and our trading partners – need smart, common-sense government regulation to reduce the risk of more bank failures, mortgage foreclosures, lost GDP and taxpayer bailouts. Citi embraces effective, efficient and fair regulation as an essential element in continued economic stability.”

When it comes to the substance, though, I’m not sure how much Pandit had to say that was new, although he took care to say it in the nicest way possible.

Here’s his first major point on regulatory reform:

“With regard to financial institution reform, we at Citi believe that banks should operate as banks, focused completely on serving their clients. Our internal reforms have been totally consistent with these principles, and we have publicly endorsed the general direction of financial regulatory reform under consideration by Congress. A systemic regulator with an overall view of the financial system and the ability to impose enhanced capital requirements and other prudential regulation is critical. I also strongly support the creation of an effective resolution authority that can resolve large, complex institutions in an orderly way.”

(Emphasis added.) Apart from the clause I underlined, the rest would not have been surprising coming out of the mouth of either Jamie Dimon or Lloyd Blankfein. The big banks have been mouthing the words “systemic regulator,” “prudential regulation,” and “effective resolution authority” for months now. They have nothing to fear from them.

Now, the “banks should operate as banks” line seems a tiny bit promising. That sounds like a reference to the “Volcker Rule,” saying that banks should get out of proprietary trading, hedge funds, and private equity. One could be cynical and say that Citi had little to lose, since they weren’t very good at any of those things anyway.

But it’s probably more appropriate to be cynical in a different kind of way, like Felix Salmon, who pointed out that Citi is getting rid of one private equity unit while keeping a different buyout operation and a VC firm. As Salmon said, “Essentially, all this boils down to ‘if you happen to be in Vikram’s good books this week, he’ll want to keep you, otherwise he’ll decide to sell you’. That’s not a strategy, it’s a monarchy.” Seen in that light, Vikram’s claim that “Our internal reforms have been totally consistent with these principles” seems a bit much.

This is Pandit’s second point:

“Regarding market reform, we support regulations that promote transparency, particularly in the derivatives markets, with the use of standardization and clearinghouses. It is also important that regulation is coordinated globally and applied uniformly to all participants in the financial sector. We need a level playing field on which market participants can compete, subject to uniform standards that protect investors and the marketplace as a whole.”

Blah blah blah blah blah. There’s nothing here.

Here’s the third point:

“With regard to consumer market reform, a key lesson of the financial crisis is that what starts as an issue that affects consumers can become an issue for the entire financial system. Recent experience reinforces the truism that what is best for consumers is also best for the financial system and the economy. I strongly believe that consumer protection can and should be strengthened at the federal regulatory level. While a number of architectural frameworks could work to strengthen consumer protection, I believe any consumer authority should be centered on five principles: (1) There should be enhanced authority in place with a focused responsibility for the well-being of consumers; (2) there should be uniform national standards that apply to all market participants who provide financial products to consumers and a level playing field, irrespective of the entity; (3) there should be transparency in disclosure so that product disclosures are simple, readable, and understandable; (4) there should be a link to the safety and soundness regulator; and (5) issues of market structure and collective action should be examined by the consumer regulator.”

(Numbers (1)-(5) added.) (1) is pure boilerplate. (2) is code for “nonbank lenders need to be regulated so they don’t have a competitive advantage over us regulated banks.” I agree, but Pandit is saying this because it’s in his self-interest. (3) is boilerplate. (4) is disturbing. This sounds like code for “don’t let Elizabeth Warren do anything to my bank without having to get the approval of Ben Bernanke and John Dugan.” (5) . . . I don’t know what (5) means. Is he saying that the consumer protection agency should have antitrust powers? That would be good. Or by saying “market structure and collective action” is he saying that the consumer protection agency should not have the power to take action against individual banks? That would be very, very bad. Unfortunately, I suspect he’s saying the latter, since the goal of the banks is to (at most) let the CFPA write rules that are then enforced (or not enforced) by their good old buddies, the prudential regulators.

So to sum up, the answer to the question in the title is: no. At least, there’s not much here to make us believe that Pandit wants real reform. Of course, the real test would be to find out what he’s paying his lobbyists to say behind closed doors. Now that would be interesting.

And this would be consistent with his introduction:

“The errors, mistakes and business practices that precipitated these macroeconomic events have been much discussed: housing policies that led to increased subprime lending in the residential real estate market; an explosion in new subprime mortgage products premised on the assumption of stable and, indeed, ever-increasing residential real estate prices based on decades of precedent; the Federal Reserve’s policy of maintaining historically low interest rates in the post-9/11 period; the growth in demand for securitized and structured credit products by investors of all types in all sectors with widely varying risk appetites and abilities to absorb risk; the lack of transparency in certain financial markets, including derivatives markets; and a regulatory system that did not keep pace with the ever-increasing sophistication, complexity and interrelatedness of the financial markets, to name just a few.”

So, in Pandit’s view, the crisis and recession were caused by: government housing policies; “subprime mortgage products” that fell out of the sky; the Federal Reserve; investors; “lack of transparency”; and the regulatory system. Do you see large banks anywhere on that list? I didn’t think so. At the end of the day, it boils down to this: it wasn’t my fault.

I started this post hoping to find something nice to say about Vikram Pandit. I couldn’t find anything.

Today, perhaps following our earlier recommendation, Mr. Vikram Pandit – CEO of Citigroup – will appear before the congressional oversight panel for TARP. (Official website, with streamed hearing from 10am).

This is an important opportunity because, if you want to expose the hubris, mismanagement, and executive incompetence – let’s face it – Citi is the low hanging fruit.

Citibank (and its successors) has been at the center of every major episode of irresponsible exuberance since the 1970s and essentially failed – i.e., became insolvent by any reasonable definition and had to be saved – at least four times in the past 30 years (1982, 1989-91, 1998, and 2008-09). 

In the last iteration, Citi was guided by Robert Rubin - self-styled guru of the markets and sage of Washington, a man who  likes to exude ”expect the unexpected” mystique – directly onto the iceberg at full speed.

Mr. Pandit was brought in by Mr. Rubin to refloat the wreckage, despite the fact that he had no prior experience managing a major global bank.  Mr. Pandit’s hedge fund was acquired by Citi and then promptly shut.  And Mr. Pandit’s big plan for restructuring the most consistently unsuccessful bank – from society’s point of view – in the history of global finance: Reduce the headcount from around 375,000 to 300,000.

Here are five questions the FCIC should ask.  This line of enquiry may seem a bit personal, but it is time to talk directly about the people, procedures, and philosophy behind such awful enterprises.

1. As far as anyone can judge, Mr. Pandit, you are completely unqualified to restructure and run a disaster prone global bank.  Can you please explain in detail how you got the job?
2. Your hedge fund. Old Lane Partners, was closed by Citi in June 2008.  Please elaborate on why it was closed, including how much money you lost on what kinds of securities.  (Hint: follow the NYT through the sad story.)
3. Please review for us the details of your promised compensation package and how much you have actually received – including cash, deferred compensation, stocks, and perks (including executive jet travel, valued at market rates); do not forget your chunk of the Old Lane deal.  How much taxpayer money has been injected into Citi and on what basis?
4. Of course, as you understand full well, the true cost to society of Citi’s misdeeds is vastly more than the direct taxpayer injections of capital.  Please tell us – as specifically as you can – what other burdens Citi has generated for the rest of us.  (Hint: there is a right answer here, which includes more than 8 million jobs lost since December 2007, a 30-40 percent increase in net government debt held by the private sector, and much higher taxes for everyone in the future.)
5. Mr. Pandit, your proposed restructuring plans simply make no sense; there is nothing you have put on the table that would reduce the risks posed by Citi to the national interests of the United States.  Even John Reed, the man who built Citi as a global brand, now says that it should be disbanded.  There is no evidence – and I mean absolutely none – for economies of scale in banks over $100bn in total assets.  Richard Fisher, head of the Dallas Fed, calls for immediate action in terms of breaking up large dysfunctional banks such as yours; please explain to us why the Fed should not move immediately to apply his recommendations to Citi – surely, the safety and soundness of our financial system is on the line.

And if Mr. Pandit replies, in response to point 5, “you need Citi because other countries have large banks,” he should be laughed out of court. Just because other countries do things badly and refuse to address their underlying issues has never stopped the United States from fixing its problems.  The basis of this republic is our ability and our right to govern ourselves. 

We should thank Mr. Pandit and his colleagues at Citi for their service and move immediately to break up their bank – just as our predecessors thanked Mr. Rockefeller and broke up Standard Oil in 1911.

In late summer or early fall, Citibank was running a promotion: if you opened a new account or moved a certain amount of money to your bank account, you would get a $200 bonus within three months. Someone I know took advantage of this promotion, but as of Monday he still hadn’t gotten the $200 bonus, so he visited a branch.

“I was given the ridiculous explanation that I didn’t surrender the promotion letter and  that the promotion code NP55 was not linked (?) in the application. I told them that: (1) the letter is not a coupon to be surrendered, (2) I should not have to tell the customer service rep how to process the promotion, (3) there was no requirement that the letter even  be presented (just go to a financial center, it states), and (4) the code only needed to be mentioned if applying by phone. They called me back in the afternoon and asked me to come back this morning. They first offered me some ‘thank you’ points, but I stood my ground.  After calling several places they finally reached a Texas office that would further research my problem. “

Eventually, he got a letter saying that Citibank would give him the $200 credit.

I’ve often wondered about situations like this: Is this just garden-variety incompetence, where the marketing folks think of a promotion and the computer guys program the systems wrong? Or is it a sinister design, in which the company decides to pull a bait-and-switch, and will only make you whole if you complain? (This goes far beyond banking. Think about any situation where you were overbilled, and after spending hours complaining you only ended up where you should have been in the first place. I’ve always thought there should be a treble-damages rule or something like it for overbilling, because otherwise companies have an incentive to overbill everyone all the time, especially if they are near-monopolists like the cable company.)

I’ve generally leaned toward incompetence, because I think if a company actually did have such a sinister plan, it would leak (because lots of people would have to know about it). But maybe it’s something in between.

Paul Kiel of ProPublica has uncovered multiple cases where homeowners are not getting their trial loan modifications made permanent. That’s not news. What is news is that the reasons the banks are giving for not making the modifications permanent are complete bogus! One person had his modification rejected by JPMorgan Chase because he made a statement that he expects his income to eventually recover; another was required by Wells Fargo to update his documentation during the trial period and then put into a second trial period because his income went up by $80 per month. (If you’re wondering why this matters, the big reason is that this way a bank can string you along making you think you’ll get a modification before finally rejecting you; if they rejected you up front, you could have walked away and saved yourself the payments in the interim.) In both of these cases, this violated Treasury Department guidelines for the loan modification program.

Here’s the thing. Jamie Dimon and John Stumpf are not reviewing documents and rejecting people’s modifications. These decisions are being made by first- and second-line servicing center employees, who are following instructions they got from . . . somewhere. What’s more remarkable, official spokespeople for both banks are cheerily giving bogus reasons for failing to make modifications permanent, unaware (until busted by ProPublica) that they are violating the Treasury Department’s rules!

So someone is taking the trouble to create inaccurate instructions for the servicing centers and give inaccurate talking points to the PR department. It could be pure incompetence, I guess. But it could be something in between–incompetence through conscious inattention. The bank’s senior executives make the decision to participate in the loan modification program, but then they don’t try very hard to make sure they are following the rules. They know that if they have a messed-up process, they can save on internal costs, and they can also drag out the trial modification periods, which means (a) more payments they wouldn’t have gotten if they rejected people on schedule and (b) longer before they have to write down the loans in question on their balance sheet. So they aren’t consciously giving orders to break Treasury’s rules, they’re just not trying hard to follow the rules, staff their servicing centers properly, train their people sufficiently, and test their computer systems thoroughly. And that way there’s never a smoking gun; instead, they can just say their servicing centers are swamped and they’re having trouble implementing new processes fast enough. (Wait! That’s what they’ve been saying about this very program for months!)

There doesn’t even need to be intent here (although there could be). Companies focus on the things they think are important. During the financial crisis, all the banks were focusing on their cash levels every day, and I’m sure they did a very good job at it. They don’t focus on things they think aren’t important. It seems like JPMorgan Chase and Wells Fargo are not focusing on their loan modification programs, and Citibank is not focusing on delivering on its promotions, just on using those promotions to suck cheap deposits onto their balance sheet. If that ends up helping their bottom line, then so much the better for them.

By James Kwak

But the question is: How to keep up the pressure and move the debate forward?  If we stop with a few verbal slaps on the wrist and a relatively minor new levy, then we have achieved basically nothing.  We need people more broadly to grasp the dangerous financial “risk system” we have created and to agree that it needs to be dismantled completely.

One way to do this would be for the Commission to call key people from Citigroup to testify.

This would not be as part of a large panel with other firms.  This would be a drill down into the history, structure, and attitudes involved in building what became the country’s largest bank – and then in driving it into the ground.  My full proposal is on the Daily Beast today, but in summary I would question Vikram Pandit and Chuck Prince at length and then pull in Sandy Weil and Robert Rubin.

This is not about the individuals; it’s about the system.  But the only way that broader mainstream opinion will change is if it sees and hears from the people who thought they had everything under control.  And – let’s face it – Citi has been at the center of all major international financial crises over the past 30 years; its alumni have top positions in our administration; and no one thinks it is a well-run organization.

It’s the human dimension of big bank hubris that will grip the popular imagination.  That and the great fortunes they accumulated at your expense.

By Simon Johnson

This is another example of a bank doing something stupid in order to say that it is no longer receiving TARP money, and probably more importantly so it can escape executive compensation restrictions. As Citigroup CEO Vikram Pandit himself said last October, TARP capital is really cheap (quoted in David Wessel, In Fed We Trust). Instead of paying an 8% interest rate* on $20 billion in preferred shares, Citigroup chose to issue $17 billion of new common shares while its share price is below $4/share. Citigroup’s cost of equity is certainly more than 8%, so it just increased its overall cost of capital. The stock price fell because existing shareholders are guessing that the dilution they suffered (because new shares were issued) will more than compensate for the fact that Citi no longer has to pay dividends to Treasury.

Paying back the TARP money also makes Citigroup weaker. That’s $20 billion less in cash it has to withstand any potential problems in its asset portfolio. Now, you can say that it compensated by issuing new equity. But those are two separate transactions; Citi could have issued the common shares whether or not it paid back its TARP money. Standing on its own, paying back TARP money is unequivocally bad for the balance sheet.

So this is bad for Citigroup shareholders and bad for Citigroup–except for the potentially important fact that Citi can now pay more money to its employees, which matters if you believe that pay is correlated with future performance (it doesn’t matter if it’s only correlated with past performance). So why are the regulators letting Citigroup do it? I think there are two reasons. The first is that they’re on a slippery slope. Once they let Bank of America pay back its TARP money, they couldn’t say no to Citigroup without confirming what everyone has always believed but that the government has scrupulously avoided saying: that Citi really is in worse shape than the other banks. The second reason is that it enables the government to declare victory and put TARP behind it, which is certainly valuable for political reasons.

What about for the taxpayer? I may differ from some people here, but I actually think it’s good for the taxpayer. We are getting our money back. The risk that Citigroup will come back for a future bailout has gone up, which is bad; but I believe that if such a bailout ever happens, it will have to be on draconian terms–a government takeover in which management is fired, shareholders are wiped out, and the company is broken into pieces and sold off. I doubt that any administration will be able to engineer another Citigroup-friendly bailout in the future.

Of course, on the way out the door, Citigroup did get one parting gift to reduce the chances that it will have to come back: an Internal Revenue Service exemption worth $38 billion. Arguably 34% of that is the government dealing with itself (since it owns 34% of Citigroup), but if the Times is right that still leaves $25 billion (about $1/share) of subsidy to Citi’s other shareholders. $13 billion of the $38 billion counts as capital for regulatory purposes, so this enables Citi to boost its capital ratio by a full percentage point (Citi’s risk-weighted assets were around $1 trillion at the time of the stress tests).

Finally, the FDIC is keeping $5.4 billion of the $7 billion in preferred shares it got from Citigroup in exchange for guaranteeing about $300 billion of assets in November 2008. More on that later.

* The interest rate on the first $25 billion was 5%; the rate on the next $20 billion was 8%. After the preferred-to-common conversion, I don’t know which rate applies.

By James Kwak

That’s Vikram Pandit on his company, Citigroup, as reported in The New York Times. What does it mean? Your guess is as good as mine.

What does it mean to “connect the world?” Sure, Citi is in a lot of places. But it is largely a retail bank — you know, the kind that you go to on the corner to take money out of your ATM. Most of its customers don’t move around the world very much. How do you “build a business” around connecting the world? This isn’t Cisco we’re talking about. And how do you “build a culture” around connecting to the world? To build a culture, you need to put together a group of people who understand the world, approach problems, and treat each other in a similar way. A new slogan won’t do it.

CEOs do have to speak in vague platitudes occasionally, but note that this was in an interview with reporters who were writing a feature article about the challenges facing Citigroup.

What Citigroup needs is a strategy. I can’t believe I’m saying this; after working at McKinsey, I thought that “strategy” was by far the most overused word in business. But what I mean is it needs some kind of story about what its customers need and what it can do well (better than its competitors), and that story has to somehow relate to what it is today. Think Lou Gerstner in the 1990s focusing IBM on services, or Larry Ellison deciding he would just buy all of his competitors and be done with it. If you’re making money, people will overlook the fact that your company doesn’t make any sense; if you’re struggling, like Citi is, they won’t.

Without such a story, it’s just a tangled mess of bad acquisitions that have no reason to be together. Now, the usual course of action in situations like this is to try to come up with a story that somehow justifies all the various bits and pieces, which gives you a story that is so weak as to be meaningless. The better answer is to come up with a story first, and then reshape the company to support that story. But that’s hard work.

Instead, a year after the crisis that would have put it out of business without extraordinary government assistance, instead of a strategy, all Citi has is a pro forma financial statement: the arbitrary division between “Citicorp” and “Citi Holdings.” As other people observed at the time of the split, there was no sound logic for how the company was split up. For example, North American retail banking and credit cards are on one side, but mortgages, auto loans, and student loans are on the other. So their plan is to run a retail bank that doesn’t lend money to households? Oh right — they’ll take the deposits and invest them in CDOs.

By James Kwak

But Smith focused on one element that got me thinking. Hall’s division, Phibro, was bought by Occidental Petroleum. “Oxy paid $250 million, the current value of Phibro’s trading positions. There was NO premium, zero, zip, nada, for the earning potential of the business. Zero. Oxy bought the business for its liquidation value.” Smith infers that no one was willing to pay more because the success of Phibro depended on its being part of Citigroup and benefiting from Citi’s low cost of funding; in other words, the massive profitability of Phibro was in part due to an accounting error — not charging it an appropriate cost of capital given the risk it was taking.

This made me think of something else, though. The typical excuse for paying traders enormous amounts of money is that if you don’t, they will leave for somewhere else. During the boom, it was certainly true that they would have left. (Whether anyone would have missed them is another question — it seems to me that some of the reasons to be skeptical of mutual fund managers apply equally to proprietary traders.) But after the crisis, the options for someone hoping to leave a major investment bank must have declined.

I’ve written so many times that reduced competition has helped the survivors increase market share and margins, but I never realized the other consequence: it gives them more bargaining power relative to their employees. There are fewer banks to go to; some of them (Citi, Bank of America) are in no shape to be paying top dollar; and while some hedge funds are doing just fine, their cost of funds must have gone up relative to the big banks in the current environment. With less competition for talent, compensation should go down, at least a little.

So why is Goldman reportedly on track to pay record or near-record bonuses this year? I imagine they would say something about how, in order to maximize long-run firm value, they shouldn’t take this opportunity to screw their employees. But if I were a shareholder, I would think a small amount of employee-screwing would be in order. This is a company that claims to live and die by the free market, after all.

By James Kwak

I have no particular complaint about Mr. Parsons; he is an experienced banker, with the very best political connections.  But I would point out that while Wall Street likes to talk big about people having “skin in the game,” when it comes to putting their personal net worth on the line, many finance executives prefer a different kind of arrangement.  Specifically, they are attracted to compensation structures in which they have a lot of upside but very little downside.

If you had such a deal, how would this affect your relative interest in risk-taking and careful supervision of subordinates?

David Brooks famously argued, a few months ago, that the problem with our banking system circa 2008 was not anything about incentives and political power, but rather stupidity.  Probably he was right that this mattered in some degree for the housing bubble. 

But what should we think about an industry that is carefully and deliberately constructing the exact same arrangements again?  Won’t this lead us inexorably towards a Truly Great Bubble?  Stupidity involving smart people in well-heeled organizations must surely be about incentives for those at the top.

Just because these arrangements involve and are being implemented by a member of President Obama’s Transition Economic Advisory Board, does that make them OK – or even remotely sensible?

And where exactly do you see the impact of the adminstration’s vaunted regulatory reforms for the financial sector here?

If your response is “well, that’s the system and there’s nothing you can do about,” you have a point.  But if that’s your response and you work in the White House, we all have a very big problem.

By Simon Johnson

The history of Citigroup’s credit default swap (CDS) spread is not so encouraging.

It’s true that in some instances during the past two years, CDS spreads have indicated pressure points, e.g., within types of lenders or across countries.  And if you can tell me how Citi survives going forward with a CDS spread around 450 basis points, I would be grateful.

The people who price CDS  obviously have every interest in assessing risk in a hard headed and accurate manner.  But Greenspan’s Lament applies to CDS traders just as much as to incentives within mismanaged banks – where in the Citi CDS spread chart do you see the build up of risk through the end of 2006?  If anything, the market for default probability was saying that Citi – and by implication the financial system with all its growing subprime vulnerabilities – was becoming less risky.

You can hope that, in the future, the market will not be so generally exuberant, but 400 years of modern financial history begs to differ.

The WSJ gets this right: regulatory capture is not only pervasive, it is by design.  But what’s the implication?

All regulators must ultimately fail and, when that happens, markets may well also misprice risk.  The question is: When this Twin Failure occurs next time, how much will be on the line? 

You cannot design a financial system that is immune to crash – this would be like declaring earthquakes illegal.  But in the aftermath of unexpectedly high damage from a serious earthquake, it makes sense to completely overhaul your building code and retrofit vulnerable buildings.  In fact, if you largely ignored what the earthquake revealed in terms of structural weakness, wouldn’t that be negligence?

By Simon Johnson

1. All the good news was in fixed income trading: $4.7 billion in fixed income trading revenues; falling revenues in credit cards, consumer banking, and private client.

2. Assets continue to deteriorate: $5.6 billion in new writedowns in trading accounts; $3.1 billion in charge-offs and reserves for bad credit card debt.

3. Accounting fictions save the day (the new bit): $0.6 billion in losses that don’t have to be classified as other-than-temporary (and therefore affect the income statement) thanks to FASB; $2.5 billion in “profits” because of the fall in the value of Citigroup’s own debt. The theory behind the latter is that Citi could go into the market and buy back all of its distressed debt, which would be cheaper than paying it off at 100 cents on the dollar. Also: $0.4 billion in litigation expenses avoided (previously reserved) and tax benefits from an IRS audit.

Point 3 adds up to $3.5 billion, which dwarfs Citi’s $1.6 billion  profit. Why is everyone so optimistic about banks these days?

By James Kwak

Right now, according to Google Finance, Citi has 5.45 billion common shares outstanding. It is offering to convert up to $27.5 billion of preferred shares held by “private” investors other than the U.S. government (like the government of Singapore and Prince Alwaleed) into common shares, at a conversion price of $3.25. That would create another 8.46 billion shares. For every dollar that is converted, the U.S. government will also convert one dollar of its preferred stock, up to $25 billion; that is the $25 billion from the first round of recapitalization back in October, which is paying a 5% dividend. (Fortunately someone realized we should convert that before converting the second chunk, which pays 8%.) That would create another 7.69 billion shares. So if everyone converts as much as possible, there will be 21.60 billion shares outstanding, of which the U.S. government will own 7.69, for an ownership stake of 36%, the number you read in the papers. (Actually, if the private investors convert exactly $25 billion and not $27.5 billion, the government would own 37%, but that’s a detail.) The other private investors would own 39%, and current shareholders would own 25%.

The government got some warrants on common shares in connection with the earlier recapitalizations. I assume the warrants it got for the first investment will no longer exist (because that first investment is being “paid back”), but the warrants on the second investment, if exercised, would presumably push the government up a couple percentage points.

Where did the $3.25 price come from? Who knows. Yesterday’s closing price was $2.46. If that price had been used, the government’s target ownership percentage would have been 38% instead of 36%, which seems immaterial. Presumably it was the product of a negotiation, since it’s hard to see how the investors involved – especially the ones that are not the U.S. government – would have wanted to pay more than the current stock price for a company that is clearly in trouble. At least they didn’t use $3.46, which is the price that any future Citigroup convertible preferred stock can be converted at.

And why did the stock plummet (now $1.57), despite the fact that the preferred shareholders are “paying” $3.25 per share? Probably because the common shareholders realize this is largely an accounting game, and the preferred stock wasn’t worth its face value to begin with. The current shareholders’ ownership stake could fall from 100% to 25%, but the stock is only down 36%. This implies that the market thinks that the total common shareholders’ stake will more than double in value, but won’t quadruple in value (the amount required to offset the dilution). Their stake increased in value because (a) Citigroup can avoid paying dividends on all the preferred stock that gets converted and (b) that much less money will have to get paid back to preferred shareholders in case of liquidation. But there’s still a large cloud hanging over Citi, and it’s on the asset side of the balance sheet.