{"id":299,"date":"2012-12-16T01:53:54","date_gmt":"2012-12-16T01:53:54","guid":{"rendered":"http:\/\/www.wallstreetandkstreet.com\/?p=299"},"modified":"2012-12-16T22:02:17","modified_gmt":"2012-12-16T22:02:17","slug":"chronic-crony-capitalist-time-for-a-break-up","status":"publish","type":"post","link":"https:\/\/www.wallstreetandkstreet.com\/?p=299","title":{"rendered":"Chronic Crony Capitalist \u2013 Time for a Break-Up"},"content":{"rendered":"

Every January an elite group of investment pros meets at the Barron\u2019s<\/strong> Roundtable to divulge their best stock ideas for the year ahead.\u00a0 In January 2007 one of America\u2019s top fund managers – -a man widely respected for his careful research, contrarian discipline, and keen eye for value — discussed one of his favorite names:<\/p>\n

I’ve got them earning $4.75 a share for 2007. \u00a0The 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.<\/p>\n

The stock was Citigroup, which declined 50% in 2007 and is now 93% below its January 2007 price.\u00a0 Oops.\u00a0 Citi shows why you have to diversify \u2014 a lot.\u00a0 In one of the more fatuous bromides in investment lore, Andrew Carnegie counseled, \u201cPut all your eggs in one basket \u2013 and WATCH THAT BASKET.\u201d\u00a0 During the financial crisis you would have watched your Citi basket drop 98%.\u00a0 In reality equity investors don\u2019t know very much about the companies they own.\u00a0 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.<\/p>\n

Citi is the defective product of chronic crony capitalism and merger mania. \u00a0I agree with Sandy Weill, who recommended splitting commercial and investment banking. \u00a0The 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.<\/p>\n

Ineffable Incompetence<\/strong><\/p>\n

Former FDIC head Sheila Bair\u2019s informative first-hand account of the financial crisis, Bull by the Horns, <\/strong>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:<\/p>\n

\u201cIt had major losses driven by their exposure to a virtual hit list of high-risk lending: subprime mortgages, \u2018Alt-A\u2019 mortgages, \u2018designer\u2019 credit cards, leveraged loans, and poorly underwritten commercial real estate.\u00a0 It had loaded up on exotic CDOs and auction-rate securities.\u00a0 It was taking losses on credit default swaps entered into with weak counterparties, and it had relied on unstable, volatile funding\u2026If 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\u2019s financial strategies.\u201d<\/p>\n

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.\u00a0 After Chuck Prince resigned, Pandit was named CEO even though he had no experience in commercial banking.\u00a0 During the crisis Citi bungled its acquisition of Wachovia, which Wells Fargo grabbed after Pandit thought he had a firm deal.\u00a0 Bair says the Citi folks \u201chad a very difficult time making decisions and then executing once the decisions were made.\u201d\u00a0 Their basic information systems were flawed; \u201cIt took them weeks to tell me how much of their foreign deposits were covered by foreign deposit insurance schemes.\u201d\u00a0 No wonder Citigroup needed multiple bailouts.<\/p>\n

Where\u2019s Darwin When We Need Him?<\/strong><\/p>\n

How did such an incompetent company become so big?\u00a0 Whatever happened to \u201csurvival of the fittest\u201d?\u00a0 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.<\/p>\n

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 \u201ccall money\u201d market.\u00a0 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, \u201cthe Federal Reserve Act does not . . . contemplate the use of the resources of the Federal Reserve system for the creation or extension of speculative credit.\u201d Maybe the legislation did not, but National City Bank did. When the Fed\u2019s 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.\u00a0 Crisis averted\u2014until October.<\/p>\n

In 1967 Walter Wriston, brilliant and aggressive, became Citi\u2019s CEO.\u00a0 Like Mitchell he circumvented regulators to grow the bank.\u00a0 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\u2019s that corporations and foreigners could buy from Citi and trade in a secondary market.\u00a0 Once he created the market, Wriston asked the Fed for permission.<\/p>\n

In the 1970s Citi and other banks \u201crecycled petro dollars\u201d by taking deposits of Mideast governments and lending to resource-poor developing nations such as Brazil and Argentina, as well asto oil producer Mexico.\u00a0 When Mexico went bust in 1982 Citi ran to Uncle Sam and the IMF for help.\u00a0 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.\u00a0 Analyst Mike Mayo calls Wriston \u201cthe 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.\u201d<\/p>\n

A Very Good Friend at Treasury<\/strong><\/p>\n

Citi had yet another near-death experience in the 1990-91 recession.\u00a0 But the best example of Citi\u2019s DC string pulling involves the 1998 merger of Travelers and Citicorp.\u00a0 The deal had a problem: it was not legal under the Glass Steagall Act, which did not permit banks to own insurance underwriters.\u00a0 Divestitures would be needed within five years.\u00a0 But when the merger was announced in April 1998 Weill opined \u201cover that time the legislation will change\u2026we have had enough discussions to believe this will not be a problem.\u201d\u00a0 Some of those \u201cdiscussions\u201d were likely with the Treasury Department, headed by Robert Rubin. In 1999 three things happened that validated Weill\u2019s forecast.\u00a0 Rubin resigned as Treasury Secretary in July, Glass Steagall was effectively overturned in November by the Gramm-Leach-Biley law, and \u00a0just coincidentally <\/strong>Rubin joined Citigroup as a top manager with no line responsibility.\u00a0 Over the next decade Rubin earned $126 million providing advice on \u201cstrategic managerial and operational matters.\u201d\u00a0 Great advice.<\/p>\n

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.\u00a0 Geithner\u2019s partner in protecting Citi was the Office of the Controller of the Currency, Citigroup\u2019s principal regulator.\u00a0 For OCC, Citigroup was definitely<\/strong> \u201ctoo big to fail;\u201d without it, there was little reason for OCC to exist.<\/p>\n

Lawyered Up<\/strong><\/p>\n

Because their core competency is lobbying, crony capitalist companies tend to fall into the hands of lawyers who don\u2019t understand the core business.\u00a0 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.\u00a0 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.\u00a0 Chuck Prince\u2019s 15 seconds of fame was telling the Financial Times<\/strong> on July 10, 2007, \u201cWhen the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you\u2019ve got to get up and dance. We\u2019re still dancing.\u201d In February 2009 Citi named a new Chairman, New York lawyer Richard Parsons who, as Sheila Bair dryly notes, was a \u201cpolitically connected insider, not someone who knew much about running banks.\u201d<\/p>\n

The Put-Together Company<\/strong><\/p>\n

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. \u00a0In 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.\u00a0 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.\u00a0 After going public, Commercial Credit acquired Gulf Insurance in 1987 and bought Primerica (which controlled Smith Barney and A.L. Williams) in 1988.\u00a0 In 1992-93 Weill\u2019s 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.<\/p>\n

Five major deals in eleven years.\u00a0 It\u2019s hard to create an integrated business when you spend all your time wheeling and dealing —\u00a0 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\u2014what one pundit calls a \u201cput together company.\u201d If they\u2019re highly leveraged banks, these unwieldy monsters are exceedingly vulnerable \u201cwhen the music stops.\u201d<\/p>\n

I don\u2019t have a fetish about \u201corganic growth,\u201d 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. \u00a0But deal machines like Citi are to be avoided. Not only are they hard to manage.\u00a0 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.<\/p>\n

A Break-up Makes Sense<\/strong><\/p>\n

Citigroup has many brilliant employees and excellent businesses. But its checkered history shows it is a defective, too-big-to fail company \u00a0that, as even Sandy Weill intimated, should be broken up into smaller, more manageable businesses.\u00a0 This would not only reduce systemic risk but benefit employees, shareholders, and customers.<\/p>\n

Sheila Bair,\u00a0\u00a0Bull\u00a0by the Horns<\/strong>;\u00a0 John Brooks, Once in Golconda<\/strong>;\u00a0 Mike Mayo, Exile on Wall Street<\/strong><\/p>\n

Copyright Thomas Doerflinger 2012.\u00a0 All Rights Reserved<\/p>\n

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