Newly uncovered emails and documents from Citigroup (C) that FOX Business has obtained reveal that Citi executives were in open insurrection against top management over risky, speculative investments that failed in spectacular fashion in early 2008, even though Citi’s sales force had touted them as plain-vanilla, safe funds to its richest clients.
What's more, Citi’s internal emails and confidential documents show Citi’s own private bankers and financial advisors felt they themselves were duped by their fellow workers about the riskiness of these investments.
That means investors could not possibly know the risks involved because even Citi’s salespeople themselves did not have the complete picture.
The Citi emails provide a rare, and chilling, reminder that Wall Street executives often tout and sell investments even they themselves don’t fully understand. Citi’s private bankers and financial advisors involved with the investments agreed that they should not have been sold, documents show.
Citi has steadfastly maintained it acted appropriately.
“Citi acted appropriately at all times in connection with these investments,” a spokesman for Citigroup tells FOX Business in a statement. “Our disclosures were accurate and complete and the investors who purchased these investments were highly sophisticated and knew of the risks involved.” The bank declined further comment.
But Citi is still battling an ongoing government inquiry, investor lawsuits as well as federal arbitration over these failed investments, which lost up to $2 billion in investors’ money on speculative investments on mostly muni bonds.
The investments at issue became nearly worthless, dropping a breathtaking 80% to 97% from 2007 to March 2008. More than 2,000 of the bank's wealthiest clients lost the majority of their initial investment, court documents show.
“The issue is that clients got duped, and we as FAs [financial advisors] got duped on what we were getting," said Jennifer Krause, a financial advisor at Citi’s Smith Barney unit, on an internal bank conference call in April 2008 after the funds failed, according to an internal bank transcript in court documents that FOX Business has obtained.
- READ: Jennifer Krause Email
Smith Barney managing director Mark Curtis -- who Barron’s would rank as Wall Street’s No. 1 financial advisor in 2008 -- on April 11, 2008, emailed Sallie Krawcheck, who ran Citi’s global wealth management business: "We will not be defensible in arbitration... It is what was told to us (FAs) and in some cases directly to the clients by the Falcon/MAT portfolio manager that will be indefensible."
And Smith Barney financial advisor Andrew Basch had already emailed Krawcheck on March 14, 2008: "Sadly for our firm this is a gigantic disaster because of lack of proper disclosure.”
Citi employees repeatedly told Citi’s top executives, including new chief executive Vikram Panditand Krawcheck, about problems even while the funds were melting down, the documents show. Krawcheck could not be reached for comment.
Krawcheck fought to refund the bank’s lucrative investors who were largely wiped out, the cream of the bank’s clientele at its Smith Barney unit, the crown jewel at Citi. But Pandit and his top executives opposed her moves, the documents show and sources close to the matter say.
The failure of these funds were partly the reason why Krawcheck, one of Wall Street’s most powerful women, was shown the door by Pandit, people close to the matter say.
The bank’s handling of these bond investments also caused the exodus of wealthy clients and traders to places like Morgan Stanley (MS), UBS (UBS), Merrill Lynch, which is now part of Bank of America (BAC), and Credit Suisse (CS).
They also created lots of headaches for newly christened chief executive Pandit, who had just taken the reins of Citigroup in late 2007. Pandit later helped engineer a huge government rescue of the bank after it nearly failed in 2009.
The collapse of the bond funds also sparked an informal inquiry by the Securities and Exchange Commission in 2008, which involved questioning the bank’s former in-house brokers. The brokers told the SEC that disclosures about the funds' risks were inadequate and that Citi executives also mismanaged the funds, the documents show.
Publicly, Citi marketed the funds, dubbed Falcon and ASTA/MAT, as “ safe muni substitutes” or “muni alternatives,” to Smith Barney clients as well as to private banking clients, according to documents FOX Business has obtained.
Behind the scenes, the lead portfolio manager for the funds, Reaz Islam, and his team used huge amounts of leverage to make speculative bets, treating the fund investments as speculative risk capital.
The fund team borrowed an average $8 for every $1 raised, at a time when the markets were about to implode. At the peak, the funds controlled about $15 billion worth of municipal bonds even though they only had $1.9 billion in investors' money.
“We were advised” that the “investments were fixed income alternatives,” emailed Skip Sussman, a financial advisor in Citi’s Smith Barney unit, to Pandit and Krawcheck on April 7, 2008.
“Fixed income, not venture capital,” Sussman added dryly. “These good folks just wanted fixed income. Collect income. Assume prudent risk, not hit home runs, and certainly not get wiped out.”
Citigroup has yet to endure the same embarrassment Goldman Sachs (GS) or Bear Stearns faced over internal emails, which showed executives behind the scenes ridiculed investments touted to unwitting clients as “shi--y” (at Goldman) while calling the markets “toast” (at Bear).
Just as Bear Stearns simultaneously was seeing two of its hedge funds crater, helping to trigger the firm’s own demise, the dramatic failure of Citi’s funds caused chaos behind the scenes at the bank, court documents show.
The stunning collapse of Citi’s investments were a stiff rebuke to former Citi chief executive Sandy Weill, whose vision of a universal bank model was based on having Citi executives cross-sell products to clients of other units, including speculative bond investments to Smith Barney customers.
Krawcheck stepped down several months after she got the bank to make a $661 million equity infusion in the investments, among other things. Investors though were still out $2 billion even after that infusion, sources close to the matter note.
The Citi case has resulted in one of the largest settlements ever awarded by the Financial Industry Regulatory Authority [FINRA] to individual, retail investors. That settlement, a total of $54.1 million -- including $17 million in punitive damages leveled against Citigroup -- was given to two investors in 2011.
The emails are surfacing at the same time a federal judge has issued a stinging rebuke to the SEC for not holding Citigroup accountable for misleading investors over a separate $1 billion fund it had sold starting in 2006.
U.S. district judge Jed S. Rakoff threw out the SEC’s proposed $285 million settlement with Citi, calling it “neither fair, nor reasonable, nor adequate, nor in the public interest.”
The Citi fixed-income funds at issue, dubbed Falcon and ASTA/MAT (short for municipal arbitrage trust), promised a couple of extra percentage points in yield above munis. Falcon invested in municipal bonds, mortgage-backed securities, bank loans and other debt instruments, while ASTA/MAT emphasized municipal bonds.
Marketing materials called the funds "an attractive alternative" to a bond index, while other disclosures said the MAT funds may experience volatility similar to the equity markets, but the Falcon fund would have low volatility similar to the bond market.
The funds would borrow at a short-term rate of, say, 3.3%, with the proceeds invested at a rate of 4.2% paid by long-term bonds.
The strategy was supposed to deliver investor returns at around 8.6%, the marketing materials said. Citigroup compared the MAT funds' risk to other bond "alternatives" such as high-yield or emerging-market bonds.
Citi’s offering documents obtained by FOX Business noted: “Asta provides investors with a stable, above-market return with little risk to principal.”
Citi’s 2007 internal business plan for both funds said: “Our goal is not to simply target hedge fund clients..but target traditional fixed-income investors who are seeking alternatives...without materially altering their risk characteristics.”
But, behind the scenes, Citi executives were growing increasingly worried that the managers of the funds were in over their heads.
A top official, Maureen O’Toole, in Citi’s global wealth management unit emailed the co-heads of Citi’s fixed income alternative investments unit in November 2007, demanding reassurance that these fixed-income funds were good for investors.
Global wealth management “has requested that the both of you take another look at the strategy/funds” and give global wealth management “the reassurance that it remains a viable strategy/fund,” emailed O’Toole in November 2007.
O’Toole added that “global wealth management has never asked for this before, but given the volatility...they feel this is a justifiable request.”
The co-head of Citi’s fixed income alternatives unit, Jim O’Brien, emailed Jonathan Dorfman, the other co-head of the unit, in November 2007, noting that the portfolio management team needs “another full-time risk person.”
O’Brien then indicated in an email that he was stymied when he tried to find out what was going on. O’Brien emailed that while he had asked a Citi investment manager for a complete, detailed list of the exact exposures in the bond funds, he then says he instead only got back an overly “broad liquid investment summary without any details.”
Then he finished off by saying: “This place is a mess!”
Another email exchange between O’Brien and Dorfman in late November 2007 noted that there was “little manager value-added to date” at the funds, and that the “lack of depth” at the portfolio management level was a problem, as the manager was “spread too thin.”
Tensions mounted, and a meeting was called between O’Brien, Dorfman and portfolio manager Islam on Dec. 18, 2007. Reaz audio taped the meeting due to concerns that O’Brien and Dorfman wanted to replace him as portfolio manager on the funds, according to a source close to the matter. Islam could not be reached for comment.
According to the meeting transcript in court documents which FOX Business has obtained, Dorfman told Islam: “I have concerns that you’ve written memos to us telling us that you’re happy with the performance of the people who work for you. Really. I mean, they’ve lost over half a billion dollars of other people’s money. If this were Morgan Stanley or Goldman Sachs, they would have been fired immediately.”
O’Brien then appears to have had lost all patience with the Falcon team because the market was already sounding alarms.
O’Brien emailed portfolio manager Islam on Dec 18 2007: “It is not like this came out of the blue. The signals started last year, we started seeing signals of a potential problem.”
O’Brien added: “Certainly by January or February , we knew there was something happening and things started to look pretty ugly. Then in the summer there was a huge eruption.”
O’Brien concluded: “So that’s what I think you’re missing, there are ways of getting yourself in position so that, when this s--t happens, you may not make money, but you don’t drop 20%. You may come out down five, down three [percent]. But making six, seven, eight, nine percent and then dropping 20 [percent] is not what people signed up for.”
Dorfman then gave "explicit instructions" to Islam to de-lever, according to the transcript. But the team failed to do so, the documents indicate.
Still, another email in January 2008 to global wealth management head Krawcheck from a Citi executive in global wealth management, Susan Wilson-Perez, noted that the top manager of the funds “has too much on his plate” and that he "can not successfully handle both" funds.
- READ: Susan Wilson-Perez Email
By that time, the subprime crisis had struck the markets. In February 2008, municipal-bond prices plummeted amid forced sales. The muni bond market went haywire and rocketed up and down that month after bond insurers, who guarantee payouts on muni bonds, hit a wall.
Especially so after the big bond insurer Financial Guaranty Insurance Co. [FGIC] suddenly lost its triple-A rating, a rating used to back the safety of muni bonds.
The Citi funds then began to die on the vine, eventually losing from 80% to 97% of their value by early March 2008, causing catastrophic losses to investors.
The losses threw Citigroup into damage-control, as it scrambled to stave off the exodus of both investors and top notch brokers, infuriated that they were losing lucrative clients over the bank’s handling of the funds.
An email to O’Brien sent in March 2008 by a Citi executive on the operational side, Michael Williams, noted his profound concern that there was a “complete lack of key controls” at the funds, adding that such risk controls were “non-existent,” including even simple controls over profit and loss statements.
Sounding the same warning bell that rang loudly about former CEO Weill’s slapping together of Citigroup, Williams added in his email that the funds were “built on duck (SIC) tape and glue.”
On March 25, 2008, Citigroup’s global wealth management unit circulated a memo, months before the lawsuits started piling up, that was entitled “Implications of Falcon and ASTA/MAT actions” which FOX Business has obtained.
In this memo, Citi officials admitted that “clients and FAs (financial advisors) feel that the risk, especially re: Falcon, was not fully articulated” to clients, that instead the fund was “marketed as effective bond alternative with limited risk.”
A few months later, Wilson-Perez emailed Citi executive Paul Hatch in May 2008 to say that even “some folks on the team feel they didn’t get the full picture on the funds.”
Gregory Chu, a top portfolio manager for one of the funds, emailed another Citi executive in May 2008, warning: “Never invest in a hedge fund within a big political organization…too many diverge [sic] interests and decisions are made not with the best interests of investors.”
- READ: Gregory Chu Email
Michael Thompson, a financial advisor, emailed Krawcheck, Charlie Johnston, CEO of Citi Smith Barney, and Hatch, head of Citi’s global wealth management, on March 19, 2008, noting he was struggling to find the words to write to his client that he had lost all of his money.
Maybe it goes something like this, he wrote. “Do you remember that municipal bond fund we invested in just last year? The one with the phenomenal track record. The one you invested a full million dollars in. Well, it is worthless,” Thompson emailed.
Newly Uncovered Emails and Documents
Mark Curtis (MD) to Sallie Krawcheck Email: "We will not be defensible in arbitration…It is what was told to us (FA's) and in some cases directly to the clients by the Falcon/MAT portfolio manager that will be indefensible."
Gregory Chu Email: “Never invest in a hedge fund within a big political organization…too many diverge [sic] interests and decisions are made not with the best interests of investors.”
Susan Wilson-Perez Email: “some folks on the team feel they didn’t get the full picture on the funds.”
Jonathan Dorfman to Jim O’Brien Email: ” This place is a mess!”
Jennifer Krause Email: "The issue is that clients got duped, and we as FAs got duped on what we were getting."
Elizabeth MacDonald joined FOX Business Network (FBN) as stocks editor in September 2007 and is the author of Skirting Heresy: The Life and Times of Margery Kempe (Franciscan Media, June 2014).
Follow Elizabeth MacDonald on Twitter @LizMacDonaldFOX.