Every January an elite group of investment pros meets at the Barron’s Roundtable to divulge their best stock ideas for the year ahead. In January 2007 one of America’s top fund managers – -a man widely respected for his careful research, contrarian discipline, and keen eye for value — discussed one of his favorite names:
I’ve got them earning $4.75 a share for 2007. The stock is trading for 11 times earnings, twice the multiple of my other picks. But [the company] is a solid 10%-12% grower. It has a 3.6% yield. They meet in a couple of weeks, and I think they’ll raise the dividend from 49 cents to 54 cents a share, which would lift the yield to 4%….Long-term it should trade at a market multiple, but I would settle for 13 times earnings in the next year. Thirteen times $4.75 would be around 62.
The stock was Citigroup, which declined 50% in 2007 and is now 93% below its January 2007 price. Oops. Citi shows why you have to diversify — a lot. In one of the more fatuous bromides in investment lore, Andrew Carnegie counseled, “Put all your eggs in one basket – and WATCH THAT BASKET.” During the financial crisis you would have watched your Citi basket drop 98%. In reality equity investors don’t know very much about the companies they own. Warren Buffett sat on the board but still did not appreciate how much Coca-Cola was over-earning in the late 1990s by pushing product on its captive bottlers. The stock collapsed over the next few years.
Citi is the defective product of chronic crony capitalism and merger mania. I agree with Sandy Weill, who recommended splitting commercial and investment banking. The next Republican presidential candidate should propose breaking up this too-big-to-fail bank long coddled by Democrats. The financial system, as well as Citi shareholders and employees, would benefit.
Ineffable Incompetence
Former FDIC head Sheila Bair’s informative first-hand account of the financial crisis, Bull by the Horns, stresses that, in a crowded field of poorly managed banks, Citigroup was in a league of its own when it came to incompetence. She writes:
“It had major losses driven by their exposure to a virtual hit list of high-risk lending: subprime mortgages, ‘Alt-A’ mortgages, ‘designer’ credit cards, leveraged loans, and poorly underwritten commercial real estate. It had loaded up on exotic CDOs and auction-rate securities. It was taking losses on credit default swaps entered into with weak counterparties, and it had relied on unstable, volatile funding…If you wanted to make a definitive list of all the bad practices that had led to the crisis, all you had to do was look at Citi’s financial strategies.”
Ms. Bair cites many other examples of mismanagement: Citi brought Vikram Pandit into the firm in 2007 by acquiring his mediocre hedge fund, Old Lane Partners, for $800 million (netting Pandit at least $165 million); Old Lane was shut down in less than a year. After Chuck Prince resigned, Pandit was named CEO even though he had no experience in commercial banking. During the crisis Citi bungled its acquisition of Wachovia, which Wells Fargo grabbed after Pandit thought he had a firm deal. Bair says the Citi folks “had a very difficult time making decisions and then executing once the decisions were made.” Their basic information systems were flawed; “It took them weeks to tell me how much of their foreign deposits were covered by foreign deposit insurance schemes.” No wonder Citigroup needed multiple bailouts.
Where’s Darwin When We Need Him?
How did such an incompetent company become so big? Whatever happened to “survival of the fittest”? Citi has thrived on crony capitalism, having an incestuous love-hate relationship with its regulators, whom it alternately ignores, manipulates and leans upon, depending on circumstances.
In the 1920s bull market it ignored them. By the end of the decade stocks were being bid up by heavily margined investors who borrowed in the “call money” market. It was a gold mine for commercial banks, which could borrow from the Fed at 5% and lend to speculators at 10-12%. On February 2, 1929 the Fed tried to quash this credit binge, announcing, “the Federal Reserve Act does not . . . contemplate the use of the resources of the Federal Reserve system for the creation or extension of speculative credit.” Maybe the legislation did not, but National City Bank did. When the Fed’s announcement caused a mini crash in stocks In March and call money rates soared to 20%, Charles Mitchell, CEO of National City, stepped in and announced he had $20 million, borrowed from the Fed, that he would lend for speculative purposes. Crisis averted—until October.
In 1967 Walter Wriston, brilliant and aggressive, became Citi’s CEO. Like Mitchell he circumvented regulators to grow the bank. Realizing that Regulation Q, which limited the rate that could be paid on demand deposits, also limited the growth of the bank, Wriston literally invented the market for large ($100,000+) negotiable CD’s that corporations and foreigners could buy from Citi and trade in a secondary market. Once he created the market, Wriston asked the Fed for permission.
In the 1970s Citi and other banks “recycled petro dollars” by taking deposits of Mideast governments and lending to resource-poor developing nations such as Brazil and Argentina, as well asto oil producer Mexico. When Mexico went bust in 1982 Citi ran to Uncle Sam and the IMF for help. The IMF lent funds to Mexico so it could continue to pay interest on loans, and the banks were permitted to carry their loans at face value for several years. Analyst Mike Mayo calls Wriston “the ultimate insider, pulling strings with connections at the Treasury Department (twice he was offered the top job in that agency), in order to ensure that his bank did not suffer the full consequences of some of its most foolish decisions.”
A Very Good Friend at Treasury
Citi had yet another near-death experience in the 1990-91 recession. But the best example of Citi’s DC string pulling involves the 1998 merger of Travelers and Citicorp. The deal had a problem: it was not legal under the Glass Steagall Act, which did not permit banks to own insurance underwriters. Divestitures would be needed within five years. But when the merger was announced in April 1998 Weill opined “over that time the legislation will change…we have had enough discussions to believe this will not be a problem.” Some of those “discussions” were likely with the Treasury Department, headed by Robert Rubin. In 1999 three things happened that validated Weill’s forecast. Rubin resigned as Treasury Secretary in July, Glass Steagall was effectively overturned in November by the Gramm-Leach-Biley law, and just coincidentally Rubin joined Citigroup as a top manager with no line responsibility. Over the next decade Rubin earned $126 million providing advice on “strategic managerial and operational matters.” Great advice.
Rubin was the mentor of New York Fed President Tim Geithner, who during the financial crisis constantly coddled and protected Citigroup, according to Sheila Bair. Geithner’s partner in protecting Citi was the Office of the Controller of the Currency, Citigroup’s principal regulator. For OCC, Citigroup was definitely “too big to fail;” without it, there was little reason for OCC to exist.
Lawyered Up
Because their core competency is lobbying, crony capitalist companies tend to fall into the hands of lawyers who don’t understand the core business. When U.S. Steel was created through a string of mergers culminating in purchase of Carnegie Steel in 1901, it had an anti-trust problem, so its first CEO was a lawyer. After Citi stepped on an embarrassing string of legal landmines, ranging from lending to Enron to manipulating the European bond market, Sandy Weill decided his successor should be a lawyer. Chuck Prince’s 15 seconds of fame was telling the Financial Times on July 10, 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” In February 2009 Citi named a new Chairman, New York lawyer Richard Parsons who, as Sheila Bair dryly notes, was a “politically connected insider, not someone who knew much about running banks.”
The Put-Together Company
The Citi we know today was created by the 1998 merger of the venerable commercial bank Citicorp and Travelers Group, a conglomerate assembled by Sandy Weil through a torrent of deals. In the 1960s and 1970s, Weill and friends created Shearson Lehman via a string of mergers and sold it to American Express, which Weill left in 1985. The next year Weill persuaded Control Data Corp. to spin off Commercial Credit, a consumer finance company; Weill invested in the company and became CEO. After going public, Commercial Credit acquired Gulf Insurance in 1987 and bought Primerica (which controlled Smith Barney and A.L. Williams) in 1988. In 1992-93 Weill’s company bought Travelers Insurance, in 1993 he bought back Shearson Lehman from American Express, and in 1997 he bought Salomon Inc., the big brash investment bank.
Five major deals in eleven years. It’s hard to create an integrated business when you spend all your time wheeling and dealing — looking for deals, negotiating deals, talking to bankers about the next deal, deciding whom to fire after a deal, deciding what you need to spin off after a deal. You end up with a disconnected collection of fiefdoms, not a real company—what one pundit calls a “put together company.” If they’re highly leveraged banks, these unwieldy monsters are exceedingly vulnerable “when the music stops.”
I don’t have a fetish about “organic growth,” and I like companies with disciplined, focused managements who understand their industry and know how to grow via deals; Thermo Fisher is a good example. But deal machines like Citi are to be avoided. Not only are they hard to manage. The complexities of merger accounting, restructuring charges, divestitures and unsustainable cost-cutting synergies make it impossible to know whether the company is really creating shareholder value.
A Break-up Makes Sense
Citigroup has many brilliant employees and excellent businesses. But its checkered history shows it is a defective, too-big-to fail company that, as even Sandy Weill intimated, should be broken up into smaller, more manageable businesses. This would not only reduce systemic risk but benefit employees, shareholders, and customers.
Sheila Bair, Bull by the Horns; John Brooks, Once in Golconda; Mike Mayo, Exile on Wall Street
Copyright Thomas Doerflinger 2012. All Rights Reserved
