Back in 2006, when the housing bubble was entering its truly (and obviously)
manic phase, mega-bank Citigroup was being pressured by Wall Street to grow
faster. And rather than pushing back against what were clearly ill-timed demands
from desperately-short-sighted analysts, Citigroup CEO Chuck Prince uttered
some words -- and adopted a strategy -- that live on in the annals of banker
cluelessness:
"As long as the music is playing, you've got to get up and dance."
Here's how Businessweek covered
the story at the time:
"The concerns are perfectly legitimate," says [CEO Charles "Chuck"] Prince. "People
are saying 'Do something!' They want to know how long is this guy going to
take?" Not to worry: "Investors will be happy to hear that Prince is dropping
hints that he's revving up the deal engine again. He laments that for the
past three years he had to stay out of the market and focus exclusively on
making existing operations more profitable. 'We're getting ourselves back
on the playing field,' he said, noting that most of the acquisitions will
be in foreign markets. There's already chatter in London that he's eyeing
Lloyds Bank or BNP Paribas.
Here in the U.S., consumers are Prince's target. "If we don't grow consumer,
the whole place has modest growth," he says. Prince is planning big branch
expansions in locations where many customers of the company's Smith Barney
brokerage business live, hoping to sell them bank products. In Boston, for
instance, Citi is planning to build 30 branches next year as a service to
30,000 Smith Barney clients. If it's successful, Citi will roll out new branches
in Philadelphia and a half-dozen other cities.
And some, at least, in the financial community think this is a good idea. "We
are impressed by [Citi's] organic growth efforts, including 785 new branches
year-to-date," said one analyst.
This, it should be noted, was one short year before the US housing market
and consumer spending in general imploded. For more on Citi's housing bubble
tragi-comedy, see Banks
and Bubbles III: "We're getting ourselves back on the playing field"
Now fast forward to the present as an even bigger global financial bubble
enters its terminal phase, and Citigroup is back on the dance floor, stomping
around to even more dangerous music. From today's Bloomberg:
Citigroup
Embraces Derivatives as Deals Soar After Crisis
In the past five years, the firm that took the largest U.S. bank bailout of
the financial crisis increased the total amount of derivatives on its books
by 69 percent, surpassing most U.S. peers and closing the gap with the market
leader, JPMorgan Chase & Co. (JPM). At the end of June, Citigroup had $62
trillion of open contracts, up from $37 trillion in June 2009, company filings
show. JPMorgan trimmed its holdings 14 percent to $68 trillion.
Citigroup is expanding as regulators try to rein in instruments that helped
fuel the 2008 credit contraction. The third-largest U.S. lender has amassed
the largest stockpile of interest-rate swaps, a type of derivative that can
swing in value when central banks raise rates. More than 92 percent of the
bank's derivatives don't trade on exchanges, making it harder for regulators
to spot dangers in the market.
"Risk-taking is in their DNA," said Arthur Wilmarth, a law professor at
George Washington University, who wrote a 2013 paper describing failures
that led New York-based Citigroup to seek a $45 billion bailout and more
than $300 billion in asset guarantees during the crisis. Even taking the
winning side of a derivative carries a risk the other party can't pay, he
said. It's "basically a speculative trading business."
Derivatives typically require parties to make payments to each other based
on the value of underlying stocks, bonds, commodities or interest rates.
Airlines and farmers use the contracts to offset price swings for fuel, vegetables
and meat. Bond buyers rely on them to insure against defaults, and some investors
use them to speculate.
Client Demand
Regulators are demanding banks keep more capital for derivatives after credit-default
swaps insuring mortgage bonds amplified losses from the U.S. housing bust.
The government bailed out American International Group Inc. (AIG), which
sold many of the contracts, to prevent the system from collapsing.
Citigroup, led by Chief Executive Officer Michael Corbat, 54, expanded the
business from a low base to meet the needs of customers, said Danielle Romero-Apsilos,
a company spokeswoman.
"We have seen gradual, risk-managed increases in interest-rate derivative
activity over the last five years as a result of client demand, which has
brought us in line with our competitors," she said in a statement.
The increase in the value of Citigroup's derivatives restores the bank to
a second-place position it hasn't held since the first quarter of 2008.
The bank doesn't disclose how much it earns from derivatives. During the
first half of the year, it brought in $6.85 billion from fixed-income markets,
including currencies and commodities, and $1.54 billion from equities. The
figures include revenue from trading derivatives as well as cash instruments
such as Treasuries and corporate bonds.
Gross Notional
Citigroup's $62 trillion of derivatives is what's known as a gross notional
figure, a raw tally of all contracts without adjusting for risk-reduction
efforts. The amounts don't represent money that changed hands and are used
to calculate payments between parties. Banks prefer to focus on net figures,
which are much smaller, in part because they can use offsetting positions
to cancel each other.
That math relies on every party paying -- something AIG couldn't do -- and
on the trades moving in opposite directions, a relationship that can break
down. In 2012, offsetting trades at a JPMorgan subsidiary in the U.K. led
to more than $6.2 billion in losses when they moved in the same direction.
Citigroup reported $44.5 billion of derivatives assets at the end of June
after backing out netting arrangements and collateral, according to filings
with the Securities and Exchange Commission. JPMorgan reported $49.1 billion.
The tendency of banks to rely on each other to net positions means one firm's
failure can cascade through the system. The danger that one party can't hold
up its end of the deal is known as counterparty risk. It means even if positions
are netted, every trade adds risk unless it's fully backed by collateral,
said Marti Subrahmanyam, a finance professor at New York University's Stern
School of Business.
"Always the concern with gross numbers is that netting could break down," Craig
Pirrong, a finance professor at the University of Houston, said in an interview.
Rising Rates
About 55 percent of Citigroup's portfolio is interest-rate swaps, which typically
involve exchanging a floating-rate payment for one that's fixed. Less than
half of the bank's interest-rate contracts are cleared, and while those
in which the firm receives a fixed payment look safe in a low-rate environment,
they can lose value when rates rise.
Some thoughts
The Bloomberg article does a good job of pointing out the absurdity of reporting
a net risk position of only 1/1,000th of gross derivatives exposure. With this
kind of leverage it will take just a few relatively minor hedge funds to fail
to bring down the whole house of cards.
And note that Citi's big recent bet is on interest rate derivatives, which
are, as the name implies, bets on the direction of interest rates. For every
up bet there's a corresponding down bet, which means the only environment in
which this market doesn't blow up is one characterized by extreme stability.
Let there be a rate spike in either direction and half the counterparties on
tens of trillions of dollars of bets are under water. The higher the volatility
the deeper the losers are buried. Let a few of them be unable to make good
on their obligations and Citi's minimal "net" exposure becomes "gross" in both
meanings of the word. Since rising volatility is the only certainty in the
decade ahead, some form of derivatives crisis is highly probable, leaving Citi
in its accustomed spot at the center of the storm.
