Le Citi Toujours Dormer...

Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:

• Citigroup had poor risk controls.
• As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.
• They weren't.
• And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.

Here they are:

The Reckoning - Citigroup Saw No Red Flags Even as It Made Bolder Bets: In September 2007... Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets.... [M]any Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers... failed to rein them in.... Citigroup’s stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago....

The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.... For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading. But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster....

From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.’s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry’s biggest players. Firms issuing the C.D.O.’s generated fees of 0.4 percent to 2.5 percent of the amount sold....

Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come.... The slice of mortgage-related securities held by Citigroup was “viewed by the rating agencies to have an extremely low probability of default (less than .01%),” according to Citigroup slides used at the meeting.... Mr. Maheras continued to assure his colleagues that the bank “would never lose a penny,” according to an executive who spoke to him....

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year. But he noted that what caused the largest problem for some banks was that they retained dangerously big positions in certain securities — like C.D.O.’s — rather than selling them off to other investors. “What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets which, in turn, led to exceptionally large losses,” he said.... Citigroup has suffered four consecutive quarters of multibillion-dollar losses as it has written down billions of dollars of the mortgage-related assets it held on its books...

The narrative structure seems to be: They did not tell the bank to wash its hands! And it caught a cold! And then it died! The villains!

This does not seem to me to be satisfactory...

Look at it this way: A bank like Citigroup has a lot of assets--a lot of people have promised to pay it a lot of money in the future. Let's collapse all those dates in the future at which people have promised to pay Citi down to one point in time four years in the future, and let's collapse all the amounts promised in the pre-crisis situation in all their different configurations down to one number $1,263 billion. Citigroup thus has assets: in four years people will pay it $1,263 billion in cash.

Citigroup also has liabilities in the pre-crisis situation. It has borrowed--i.e., accepted deposits (that is what a deposit is: the bank has borrowed money from you, but they call it a deposit rather than a borrowing so that you will think that what you put in the bank is still there) and issued notes to the tune of $800 billion.

So Citigroup in this pre-crisis situation has assets of $1,263 and liabilities of $800 billion and thus is worth $463 billion right? Wrong. The $800 billion is essentially due tomorrow--if the depositors and creditors want to get it out rather than roll it over, they can do so. The assets are in the future and are uncertain. Future assets are worth less than current assets: this is the time discount on safe assets. Risky assets are worth less than safe assets: this is the risk discount. With a (safe) time premium of 4% per year and a risk premium of 2% per year, Citi's assets are worth 6% less on the open market today for each year they are in the future. Compound this over four years and you get a risk factor of 0.792. In this pre-crisis situation, Citi's assets could only be sold on the open market for $1,000 if they had to be sold immediately. But you still have a healthy bank: assets with a present value of $1,000; liabilities with a present value of $800; a net worth of $200 billion.

But things can go wrong:

1. You can learn that you were always mistaken about the value of your assets--that they were always really worth less than you thought they were.
2. You can learn bad news--that your assets used to be worth what you thought they were, but bad unexpected things have happened to your assets and they are worth less. (They are, after all, risky things to own: that's what "risky" means: bad things can happen and values can go down.)
3. The safe rate of time discount can go up because of a liquidity crunch: people suddenly value cash now more than cash later by a greater degree. This will push the discount factor down and make the present value of your assets less even if you have had no bad news of any kind about their long-run value.
4. The risk premium rate of time discount can go up because the market is no longer as tolerant of risk, or no longer as tolerant of your risks as it used to be. This will push the discount factor down and make the present value of your assets less even if you have had no bad news of any kind about their long-run value.

So now you have the post-crisis balance sheet of Citi:

As best as I can guess, things (1), (2), and (4) have gone wrong:

1.Citi's (and everybody else's, it seems) risk models were wrong: assumed that the tails of distributions were much too thin--never mind what they were doing making calculations based on tail densities about which you inevitably have no information at all anyway). This seems to have cost Citi about $30 billion in impairing the future value of its assets.

1. We have gotten bad news about housing prices, independent of the erroneous distributional assumptions in the risk models. This seems to have cost Citi another $30 billion or so in impairing the future value of its assets.

2. Has been working for Citi, not against it: the Federal Reserve has pushed short- and medium-term safe interest rates down far to diminish the magnitude of the liquidity premium--the preference for cash now rather than cash later. This would have raised the value of Citi's assets but for...

3. ...the explosion of the risk premium. The risk premium on other investment banks's assets has gone from 2% to 6% or so. Citi's premium has gone up to 8% because it right now bears the additional risk that the government will step in and nationalize it, confiscating much of the shareholders' equity stake in the process.

Should Citi's management have planned for and guarded against this explosion in the risk premium? I certainly did not expect it--I did not think we could see this big a rise in the risk premium outside of a real cousin of the Great Depression, and I thought that modern tools of macroeconomic management would keep such a thing from happening. I never expected to see the unemployment rate hit 15% in my lifetime. I still don't.

It's in the nature of a bank to get into trouble and be on (or over) the edge of failure in a financial crisis. Banks exist to provide liquidity and safety: to turn the long-term highly-risky investments in plant, equipment, and infrastructure that are our social capital into the short-term liquid largely-safe assets that savers largely want. This means that banks are--if they are doing there job--long duration and long risk, and their values crater whenever there is a financial crisis because a financial crisis is a sharp fall in the value of long-duration and high-risk assets.

A bank that has not lost massive amounts of value in the past year and a half is either extremely nimble or extremely lucky: even the nimble and lucky JPMorgan Chase has lost 60% of its shareholder value in the past year and a half.

The question of how much duration and risk a bank should assume per dollar of capital is a knotty one--if you match durations and assume no risk, then your stock value never crashes. But shareholders are paying you to be a bank, not to be a not-bank. Rubin has a lot of big wins in his career: as a risk-arbitrage trader, as head of Goldman Sachs, the 1993 budget, the 1995 Mexican rescue, the 1997-98 East Asia crisis--that suggest that his judgment is generally good, and that he takes aggressive but appropriate risks that are in the interests of his principals. You got to know when to hold 'em and know when to fold 'em, but even if you do you may still break even.

The article says that Bob Rubin is racking his brain right now trying to think of what he could have known or could have learned back in 2005-6 that would have told him that Citigroup had taken on too much subprime mortgage risk, or that its internal risk-management controls were deficient:

Asked then whether he had made any mistakes during his tenure at Citigroup, [Rubin] offered a tentative response. “I’ve thought a lot about that,” he said. “I honestly don’t know. In hindsight, there are a lot of things we’d do differently. But in the context of the facts as I knew them and my role, I’m inclined to think probably not.” Besides, he said, it was impossible to get a complete handle on Citigroup’s vulnerabilities unless you dealt with the trades daily. “There is no way you would know what was going on with a risk book unless you’re directly involved with the trading arena,” he said. “We had highly experienced, highly qualified people running the operation”...

Comments

[howard]

prof, regardless of what you, me, and the lamp post may have thought, it certainly seems to me that everyone in the financial sector has earned a highly increased risk premium, wouldn't you say?

[James Gary]

Question: are the risk and time premiums used in the example the actual rates, or just dummy figures used here for the sake of demonstration?

[They are just my rough, aggregate guesses.]

If they're the actual figures, how exactly are they arrived at? is there a quantitative method for assessing risk on a particular investment, or is it just educated guesswork?

[Citigroup has 350,000 people working for it. Valueing and keeping track of assets and liabilities is what they do.]

[nathan]

It seems taht the Paulson or the feds u-turn on TARP (away from mortgagtes, or securities related to mortgages and real estate, and toward consumer loans or securities back by consumer loans) did not have an ameliorative impact on Citigroup.

[CSTAR]

Le citi n'a meme pas eu le temps de se dire "Je m'endors"...

[James Gary]

[Citigroup has 350,000 people working for it. Valueing and keeping track of assets and liabilities is what they do.]

...and they were all massively wrong? The central thesis of the original post seems to be that the Citibank's problems are due to "erroneous distributional assumptions in the risk models." What specifically were these "erroneous assumptions?" Is there any quantitative way to describe them? Please advise.

[satchmo]

Citi dort bien... Or perhaps: Citi,ça dort sec! Or: Citi se somnambulise!

[jrw]

Okay, so Dash and Creswell have the wrong narrative. What I still don't understand from reading your post is, what is the correct narrative? That Citibank's problems "just happened" and that no one could have foreseen them? That the problems really aren't as large as they're being made out to be? I'm confused.

[Daro]

You can't work out CitiGroup's logic. They've been rogue with their accounting ever since Sandy Weill (who oddly enough is not mentioned in the article). It would be reckless of me to suggest, in addition, that all manner of things went off the books about the same time the money laundering stepped up so I won't say it. Anyway, here's an example of an ordinary day for Citi:

...After an investigation showed that Weill had implicitly solicited a bullish rating on a stock from analyst Jack Grubman in exchange for arranging admission to the 92 Street Y's elite preschool for Grubman's twins, Weill found his reputation tarnished and his ability to run the company restrained by regulators...

[bob mcmanus]

I certainly did not expect it--I did not think we could see this big a rise in the risk premium outside of a real cousin of the Great Depression, and I thought that modern tools of macroeconomic management would keep such a thing from happening. I never expected to see the unemployment rate hit 15% in my lifetime. I still don't.

Hoocudanode? Not an economic historian?

You know what? I. Don't. Believe. You.

[Graydon]

If everyone has a common busted axiom, everybody can be (in good faith) the same kind of wrong.

There are two busted axioms involved in the current US meltdown.

One, that the proper purpose of the economy is to concentrate and preserve wealth in the sense of large amounts of money. This doesn't actually work because money is a side effect of productive activity, not an independent thing, and profit-maximization will eventually damage the productive activity enough to cause either a correction or a crash.

Two, that the complex financial instruments that assigned risk to various debt obligations in optimistic ways did not functionally constitute support of bank profits through counterfeiting. (Remember that with a fiat currency, banks are effectively creating money when they make a loan; value from the future is arriving, suitably discounted, in the present.)

The idea that no one running the big machine was aware of axiom one boggles my mind; there are enough previous examples of the problem that I'd expect there are MBA courses on optimizing your balance between profit now and profit later.

Axiom two is a new problem; with luck this is going to be the only example. I can just about imagine someone at Rubin's level not being able or willing to believe that the horde of underlings would do something so completely crazy, but he -- and everyone else at a similar level of responsibility -- ought to have known and ought to have done something about it.

There are classes of error where, either you knew, and are hung for collusion in the wrongdoing, or you ought to have known, and are broken for incompetence.

I'd say the current US financial meltdown belongs in that class of error.

[Stephen Purpura]

Bloomberg did a piece on Citibank's off-balance sheet assets in March. The full assets of the company are used to secure loans related to these assets. Here is the graph:
http://www.bloomberg.com/apps/data?pid=avimage&iid=iotLcq3doU6I

My question: aren't most investors still concerned about losses in Citibank's off-balance sheet investment vehicles? If not, why not? And how was this factored into the analysis?

[Charles]

Brad, I think you're missing the real reason Citi's value has collapsed.

Suppose you have 100 tins of sardines, valued at $1. Five and only five of them are poison. As soon as the wrapping is taken off, it will be obvious which are poison.

However, you do not know which is which, you can't take off the wrapping and you are required to sell them in lots of 10.

Any buyer will give you $5. They take off the wrappings and are certain of finding no more than 5 tins that will need to be discarded.

But how many buyers will give you $6, $7, $8, $9, or $10? If money is extremely tight, and all five happen to be in the same lot, the buyer will be bankrupt. This is not included in your four cases (although #3 is a factor in this illustration).

I think that fear of catastrophic consequences is what's behind the drop in Citi's assets. If we could unravel the mortgages from the CDOs, we could solve the mess almost overnight.

[Mayson Lancaster]

Has Banco Santander been nimble, lucky, or perhaps just wise?

6.9B euro profit, first 3 Q '08

Is there another bank in the world that made 2.2 B euro last quarter?

[tena]

i find it to funny that citi rushed to buy my mortgage accounts, constantly posted the payments in the afternoon of day due, but declared them late in the morning. you'd come home to 5 or 6 calls each time. mind you, payment isn't even late yet (grace period). then posted bankruptcy attorney fee on accounts, called lawyer, lawyer called them. next month it's a deliquincy fee, nothing lawyer can do about that. all in all i hope they fold, they have shown their true greed in not wanting to work things out. think of the money they would save in the costs of 5 calls a day and 2 times a week mailing for someone who's payment is not even technically late (grace period and them manipulating the posting time) or maybe thats what they are putting that $25 billion of taxpayer money into. i for one say they have made their beds, now its time to go to sleep.

[MattYoung]

Another mammoth bankruptcy,

Whocodanon?

Everyone knew. go back and look google articles about with the Asian savings glut, federal deficit, and consumer debt.

Why did we all decide to fix our personal finances in these particular few quarters?

Gotta go, babysitting

[jh]

Love yr blog, Brad, but please, the headline just isn't French. What I think you wanted was "Citi dort toujours" (Citi is still asleep").

[nathan]

banco Santander: may be more inflation in relevant market or inflation of different nature. This inflation may save debtors and lenders. If real estate in US went up or even flat, banks in US might be in relatively better shape

[Steve J.]

It's the hidden stuff that's giving people the creeps...

Bailout Talks Accelerate for Ailing Citigroup
Billions in Toxic Assets May Be Removed; New Phase for Government Bank Rescue
NOVEMBER 24, 2008
By DAVID ENRICH, CARRICK MOLLENKAMP and MATTHIAS RIEKER
Wall Street Journal

In addition to $2 trillion in assets it has on its balance sheet, it has another $1.23 trillion in entities that aren't reflected there. Some of those assets are tied to mortgages, and investors have worried they could cause heavy losses if they are brought back on the company's books.

[christofay]

le citi dort avec les poissons, les vies exécutives de compensation dessus

[Twofish]

Something that is also important is the time element. When things start going bad, how quickly do they start going bad. The danger is the classic bank run. Once your balance sheet starts going bad, people want their money which causes your losses to increase.

The in the case of Bear-Stearns and Lehman Brothers, this run unfolds very, very quickly. The stock in both companies plummeted within a week. The reason for this is that their business model involves borrowing short term to fund long term. If you have a bank run, the short term borrowing stops, and you are dead. In the case of Lehman and Bear-Stearns, things were happening on an hour-by-hour basis.

In the case of Citigroup, it has insured deposits and a liquidity line with the Federal Reserve. This means that when something bad happens, it falls apart much more slowly, and this gives you time to think about what to do. The thing that you have to be careful about is not to do anything that makes the problem worse. If you have a crisis of confidence, then saying or doing the wrong thing, just panics people even more. On the other hand, the other danger is that by doing nothing on the theory that doing something will panic people, you run the risk of looking as if you are out of touch and this panics people even more.

Also if you look at the systemic long-term problems at Citigroup there are two:

1) Citigroup has more employees maintaining the same amount of money as the mega-banks. The layoffs at Citi have been more than its competitors, because the pre-crisis employment numbers were higher.

2) The business model that Citigroup was advancing when it pushed for the passage of Gramm-Leach-Billey never quite gelled. The idea was that Citi would be your one stop financial services shop, but they never were able to quite to get this to work.

[Twofish]

James Gary: The central thesis of the original post seems to be that the Citibank's problems are due to "erroneous distributional assumptions in the risk models." What specifically were these "erroneous assumptions?" Is there any quantitative way to describe them? Please advise.

The basic erroneous assumption involved calculating the probability that one mortgage will go bad if another goes bad. One way of thinking about it is that one way of calculate the chances that one window will break if another breaks is too look at historical window breakage rates, and think about how likely it is that one window break will cause other window to break.

The problem comes in is if you have a category five hurricane hit, then all of the windows will break at the same time. It's worse if you are looking at a place in which a hurricane has never hit before. The two things that the risk models didn't consider were

1) when one thing goes bad, everything will go bad, and

2) just because something has never happened before, doesn't mean that it can't happen. There were probably some meetings a few years ago where someone said "the only way we could get into trouble is if we have a repeat of 1929." This is great, until you have a repeat of 1929.

This gets to a very deep philosophical problem which is causing lots of problems right now. You generally deal with the future by looking at the past, but if you are in a situation where you have something that isn't quite like anything you've ever seen, what do you do? How do you predict the unpredictable or know the unknowable?

Finally there was one particularly bad assumption. In every CDO model I've seen, the assumption was that you'd be able to recover 40% of the value of the loan. This is partly because CDO models and CDO's were originally designed around corporate bonds, and when a corporation goes under, there is a very well organized process for keep the corporation alive and settling losses, and 40% recovery isn't an reasonable assumption if you are creating a security off of corporate bonds.

It turns out to be a very bad assumption for subprime mortgages. When a corporation goes bad, you still usually have a factory or some inventory that can be quickly sold, whereas when a house gets foreclosed, you end up with something that may be unsaleable. Also it's bad because if you are creating a CDO off of a security of mortgages instead of mortgages themselves, you end up concentrating risk.

[Twofish]

There is one more point that needs to be made, and what is why Citi started really having problems last week and not before that. After all, Citi's balance sheets and it's holdings of mortgages had been known for years. Why did everyone suddenly panic last week?

The reason for that is that it's dawned on everyone that we may be in for a really bad recession. If it were the situation that all Citi had to do was to write down subprime, then there wouldn't be a problem. What has people spooked is not the subprime (since we've known about that for months), but if we start getting 8-10% unemployment rates, then people will stop paying prime mortgages, credit cards, auto loans, and student loans. If all those go bad, then what had been great assets before now turn into duds.

So we really are looking at a bad cycle. If something bad happens to GM, you have unemployed workers defaulting on their auto loans and credit cards, which affects Citi, which then affects more companies, etc. etc.

What's worse is that we were in a post-election gap in which there was no one that could get on television and say "we're working on this and everything is going to be all right."

The one piece of good news is that the "road to hell" happens week by week which gives you time to stop the spiral down. In the case of Lehman and Bear-Stearns, the "road to hell" was happening hour by hour.

[Twofish]

Something else that needs to be mentioned. The deal that the Feds negotiated with Citi is going to be the starting point in case any of the other mega-banks get into trouble. So if you want to look at contingent liabilities, you need to take Citi and multiply by four (Citi, BoA, JPM Chase, Wells-Fargo).

One thing that sort of amuses me is how much the US banking system is starting to look like the Chinese banking system with its four big banks (CCB, BOC, ICBC, ABC).

[Twofish]

Some other things to watch out for:

1) The 3 p.m. rally/crash. The reason that the stock market tends to rally/crash at 3 p.m. is that hedge funds and mutual funds have to put in their orders early in the day, and then all get executed starting at 3 p.m.

2) The Sunday announcement. Big announcements tend to be announced Sunday evening because it gives people the weekend to figure out what to do in a way that the markets aren't dropping or rising with each rumor.

3) Three financial centers. There have to be three financial centers in the world to do 24 hour trading. One in Europe. One in North America. One in East Asia.

[christofay]

If you want to start trying to run ahead of the ball, then you have to start planning on what to do in case of a Fed Govt funding crisis. The implosion of inno-finance is already happening. The next step is at what rates are we going to be funding our borrowing, how much inflation is brought into the system, where will the funding come from? The democratic congress has shown yet again with the recent Lieberman issue that responsibility is not tolerated in Wash D C.

[q___j]

Brad, wouldn't the government make us all a bit richer by buying shares of Citi now? The high risk premium should represent two risks related to Citi:

- doubts about the real value of the assets (your reason 2)
- doubts about the liquidity of Citi. Insufficient liquidity might force them to sell assets in the current market environment below their real value.

In case the government would buy a large share of Citi the risk premium due to liquidity doubts should vanish, correct? Assuming that half of the additional risk premium of 6% is due to liquidity, the discount rate would drop to 7% (2%+2% (old risk premium) + 0.5* 6%), which would increase the value of Citi's assets from $820bn to $915bn. In case the government would increase Citi's capital by $20bn, thus obtain 50% of Citi's equity, the new value of equity would be $20bn (current value) + $20bn (cash from government to buy 50% of Citi) + $95bn (higher asset value due to drop in capital costs) = $135bn. I.e. the value of the share of Citi that is owned by the taxpayer would increase from $20bn to $67.5bn thanks to no public liquidity constraints.

This would be good for all of us (including the current shareholders of Citi), but the crucial assumption is that the 5% non-liquidity risk premium is sufficient to cover potential value corrections of Citi's assets.

[merkey]

Mr DeLong,
How can your "analysis" not mention the enormous off-balance sheet vehicles of Citigroup, the unprecedented banking ratios (if you include the off-balance sheet entities), how much of an innocent would you have to be to think we werent in a housing bubble in 2005 or a private equity bubble in 2006?

And yet Citigroup and its bosses are the victims here? They just were nimble enough, or maybe they were unlucky?
Nonsense, they were grossly irresponsible. THey didnt give a damn because they knew they could make enough to last a lifetime in a few years and they could palm it all off on Uncle Sam when it all collapsed.

I can't understand how they are allowed to get away with this. How, after Enron, can Citigroup executives be allowed to get away with running massive off-balance sheet vehicles?

And I don't know why you want to defend these pond scum

[merkey]

Didn't Paulson only last week say that he was done with the bailouts for now. And a week later he is having to launch another massive bailout for Citigroup.
How is this possible? Because this means that either Paulson is utterly clueless or Citigroup was lying about its position right up until last week. Thanks for that Mr. Rubin.

[MQ]

Rubin used to be Brad's boss at Treasury. Rubin was the patron of all the rising Democratic policy economists in the Clinton era, who are now taking over the most senior posts in the Obama administration. Brad is never going to seriously criticize Bob Rubin.

[Jerry]

"There are classes of error where, either you knew, and are hung for collusion in the wrongdoing, or you ought to have known, and are broken for incompetence.

I'd say the current US financial meltdown belongs in that class of error."

Indeed - this seems incontrovertible. If not now, when?

[robertdfeinman]

Perhaps it was just a simplifying assumption to make the numbers easier to understand, but the funds loaned to Citi are not all demand deposits.

A large fraction of them are in the form of bonds, preferred shares and other instruments which don't have to be redeemed until the future.

Several firms have now even issued perpetual (callable) preferred shares (I don't know if Citi has done this as well), which means they don't ever have to pay back the principle if they don't wish.

Citi's problems, whatever they really are, are being confused with the change in the price of its common stock and tradeable existing bonds. Speculators may be unhappy with their losses (as are the top management with their options), but this has no direct bearing on how the company is performing. The most you can say is that the low prices for these instruments, caused by doubt, will make it harder for Citi to raise funds in the future.

They, like all the other "banks" are suffering from a cash flow problem and the need to balance the books to meet federal reserve requirements. The former is a problem of not having enough money to run the day-to-day operations. The latter is an accounting book entry and can be changed at any time as the Japanese government did when it's banks ran into trouble in the 1990's.

[Nell]

trying to think of what he could have known or could have learned back in 2005-6 that would have told him that Citigroup had taken on too much subprime mortgage risk

How about the little fact that Michael Eisman stumbled on -- that the ratings agencies' models operated entirely on the assumption that housing prices would only go up? Literally; the models had no provision for negative values to be entered. (See Michael Lewis' 'The End' in Portfolio)

[xfire]

"Didn't Paulson only last week say that he was done with the bailouts for now. And a week later he is having to launch another massive bailout for Citigroup"

That is exactly what caused the run on C. They were perceived as the one with the worst assets and would have to carry it on the books instead of selling it to TARP.
Also, the bearish CDS trading , a la Morgan Stanley in September , was starting to happen to C.

"The 3 p.m. rally/crash. The reason that the stock market tends to rally/crash at 3 p.m. is that hedge funds and mutual funds have to put in their orders early in the day, and then all get executed starting at 3 p.m."

For circuit breakers to happen after 2:30 PM, the market has to drop by more than 2200 points. The hedgies have a good chance of trades going thru' without the market stopping after 2:30 PM than before, when the range is tighter.

[Richard Cownie]

It seems that banking is fundamentally a confidence game: people lend money to banks only because they have confidence that the bankers won't do something utterly stupid with it and be unable to pay it back. And it's especially true that people pay a lot of money for bank stocks because they think the bankers are going to be smart and make a big profit. Right now nobody has any confidence in either of those propositions.

What is the value of a dentist's business ? And how does that value change if one person's teeth happen to turn black overnight ? Not much, right ? But what if the person whose teeth turn black is the dentist herself ?

That seems to be the underlying problem: it's horribly apparent that all these bankers just never knew what the hell they were doing. And once you know that someone's a fool, owning a stake in their business seems like a terrible idea. I guess in your rough model that means the risk premium has gone insanely high. But it's simpler just to say that no-one wants to hand their money over to these fools any more.

And that points to a big problem with the current attempts to recapitalize the banks: you can give them capital, but you can't stop them looking like fools. We may need completely new institutions, or at least completely new management and much more thorough regulation, to re-establish any kind of trust.

[Don the libertarian Democrat]

Your defense of Sec. Rubin reminds me of a lesson I learned many years ago while playing Babe Ruth League baseball.

In a tied game, with two out, in the bottom of the last inning, I was on third base. I came up with a brilliant, if risky, plan, all on my own. I decided to steal home.

Now, I was pretty fast in those days, and I knew that my decision was the last thing anyone expected, so I convinced myself that it was a brilliant and foolproof plan.

I was thrown out. When I got to the dugout, the coach said, " What the hell do you think you were doing? ". I said, " Trying to score a run and win the game, that's my job". He replied, not that impressed, "It's not your job to be thrown out in an idiotic play".

Well, true enough. I'm not equating my risk with Rubin's, but I did learn one thing that day when we lost. That was to take responsibility for your own risks. Period.

[Neal]

At what point does this kick in?

from the GAO

(quote)

Antideficiency Act Background

The Antideficiency Act is one of the major laws through which Congress exercises its constitutional control of the public purse. It evolved over a period of time in response to various abuses.

In its current form, the law prohibits:

Making or authorizing an expenditure from, or creating or authorizing an obligation under, any appropriation or fund in excess of the amount available in the appropriation or fund unless authorized by law. 31 U.S.C. § 1341(a)(1)(A).
Involving the government in any obligation to pay money before funds have been appropriated for that purpose, unless otherwise allowed by law. 31 U.S.C. § 1341(a)(1)(B).
Accepting voluntary services for the United States, or employing personal services not authorized by law, except in cases of emergency involving the safety of human life or the protection of property. 31 U.S.C. § 1342.
Making obligations or expenditures in excess of an apportionment or reapportionment, or in excess of the amount permitted by agency regulations. 31 U.S.C. § 1517(a).
The fiscal principles underlying the Antideficiency Act are really quite simple. Government officials may not make payments or commit the United States to make payments at some future time for goods or services unless there is enough money in the "bank" to cover the cost in full. The "bank," of course, is the available appropriation.

Violations of the Antideficiency Act are subject to sanctions of two types, administrative and penal. The Antideficiency Act is the only one of the title 31, United States Code, fiscal statutes to prescribe penalties of both types.

(end quote)

Another set of laws and congressional authorities that the Bush administration has managed to eviscerate. And, oddly enough, their actions benefit their friends and accomplices in the looting of America.

[Vasilis]

Prof Delong,

No comment at all on the bailout? It looks like Citi, with Mr Rubin helping out, did quite well for itself. Especially the management.

[Ken Houghton]

"This would be good for all of us (including the current shareholders of Citi), but the crucial assumption is that the 5% non-liquidity risk premium is sufficient to cover potential value corrections of Citi's assets."

YOURS, in size, as a naked short.

Rubin gets to the heart of the matter, and yet D&C still try to blame him:

“There is no way you would know what was going on with a risk book unless you’re directly involved with the trading arena,” he said. “We had highly experienced, highly qualified people running the operation”...

As Felix Salmon noted, it wasn't Robert Rubin who was "running the operation." Unfortunately for The Big C, you go to investment with the risk management team you have--a backwards-looking one--not the one you think you should have.

[just a yob journalist]

C'mon, Brad, I know it's difficult for you to accept that your patron Rubin may have blundered, but as much as I admire much of his record, your defense of him isn't all that convincing, if for no other reason than you turn a blind eye to linkages among your four horsemen of the apocalypse.

If 1 and 2 in your list of bad things happen, then chances are that 4 does as well--in other words, if asset prices collapse, odds are that risk premia are going to shoot skyward. Any bank--but especially Citi---should have seen that. Any reasonable risk management system should have seen it too.

Of course, the even bigger question is why Rubin and bankers in general could ever have missed the real estate bubble. It wasn't exactly hidden. Robert Shiller and Dean Baker spent years warning people of it. So Citi is either a bit dim (in which case, management, including Rubin, should be kicked out with great alacrity) or they were greedy and hoping to make an extra buck before the roof caved in (which case, they should be kicked out with even greater alacrity).

[Measure for Measure]

Some evidence of managerial incompetence:

1. Models with dubious assumptions. Models with insufficient (laughable?) stress-testing:

" ...Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. ...

Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities. "

2. Mismanagement of people and insufficient analysis of their CDOs, reliance on credit rating agencies:

"Yet as the bank’s C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell — setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.

C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves. "

-----
That said, parsing out Citibank's balance sheet is a useful exercise.

[howard]

jeez, you would think a buncha seemingly savvy people would know that robert rubin was not an operational executive at citi, but i guess they don't.

he's part of the executive team and can't escape being part of the executive team, but the idea that somehow, really, this is all just robert rubin's fault for not being as smart as dean baker isn't really well-grounded.

again, citi's problem isn't, per se, failure to recognize a housing bubble: it's much more structural than that.

[erewhon]

No doubt that Mr. Rubin is a smart man who has a good side. However, he and Mr. Greenspan wreaked havoc with their bubbles and excessive liquidity, their love of derivatives and Greenspan's promotion of adjustable rate mortgages (I don't recall Rubin publicly endorsing ARMs like Greenspan did).

These guys will go to their gilded graves rolling in money while millions of Americans suffer serious injury, even more stressful retirement, etc... Don't tell me to feel sorry for Citi or accept the disgraceful feculent bailout that Bernanke and Paulson have wreaked upon us. Why not send Bernanke, Greenspan, Paulson & Rubin to permanent exile in Antarctica?

Has Larry Summers learned the lesson?

[Don the libertarian Democrat]

Robert Rubin is coming under a lot of fire today for pushing risk at Citi based on this quote:

“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more."

Now, I want to make my position perfectly clear. Sec. Rubin should be held accountable for that advice and those decisions. Brad DeLong's comments seem to want to exonerate Sec. Rubin, but he needs to justify those decisions himself. It is a truism to say that Sec. Rubin's job was to make money by taking risks. Good point. It adds nothing to the discussion. The discussion is about how well he did that job. There's no worry about him being assessed, he'll have lots of company.

However, from my point of view, Sec. Rubin is the hero of the whole article. He seems to be one of the few people involved who admits that CDOs were riskier investments, intended to make more money by extending risk. How many times have I read the following:

These CDSs and CDOs, we were assured that, even though they were chosen because of their lower capital requirements, we were assured that they were less risky by models created by physicists, phrenologists, cosmologists,cosmetologists, all sorts of really brainy chaps,with all sorts of really obscure mathematics only they could decipher. So, we were totally unprepared for risk. We'd been told that there wasn't any. That was the beauty of these investments. Lots of money with no risk.

So, I'm exaggerating, but Sec. Rubin deserves a medal for understanding and owning up to the risky nature of CDSs and CDOs, which, although complicated, can be explained to average investors using simple phrases like "riskier", "less tested", "complicated", etc.

[Movie Guy]

Brad - "Should Citi's management have planned for and guarded against this explosion in the risk premium? I certainly did not expect it--I did not think we could see this big a rise in the risk premium outside of a real cousin of the Great Depression, and I thought that modern tools of macroeconomic management would keep such a thing from happening."

Brad, how could you not have expected a problem with CDS exposure when the general level of CDSs was in excess of $62 trillion for the mortgage related industry alone?

I have to wonder if you're current on the level of CDS exposure among the Detroit Three. If not, you may be surprised again.

[pw]

Seeing that the just-announced bailout includes more than $300 billion in "troubled" assets, the fault seems to go well, well beyond CDOs. And yes, the risk premium goes up when no one believes that all (or even almost all) of the people who are supposed to pay Citibank that trillion-plus in four years will be around. A 6% risk premium would suggest three quarters of those notes will be good, but since no one has any effing clue about the quality of anybody's balance sheets these days, it could be 90%, it could be 50%.

[srb]

The 8% "risk premium" in Brad's example needs to be decomposed into expected writeoffs + "true" risk premium. Expected writeoffs will be Citi-specific (the 6 vs 8 percent in Brad's example). Brad simply asserts it is coming from fear of government takeover. But consistent with the NYT article it is at least as plausible to believe that investors have no faith in Citi's internal risk analysis and controls so were factoring in a large amount. Which better explains the rise in value in response to the bailout? I suppose it could be less fear that the gov't will bankrupt a solvent business (Brad's explanation), or could be that the gov't has put a floor on the losses - which is what the gov't said it was doing. Should would be nice to have some more from Brad on why he thinks his explanation is better before trashing the NYT piece.

[David Blumgart]

Could I just say that pieces like this post (and the discussion it engendered)are why I keep coming back to the site, no matter how often I'm provoked by other posts I hold in rather less regard. Nice work.