Ghosts of Lessons Past

When the subprime mortgage market collapsed in the fall of 2007, Citigroup was sitting on a $43 billion portfolio of mortgage-related assets that had been accumulated by an aggressive team of traders, according to an article last November in The New York Times. It was shocking to read that Charles O. Prince III, who was the bank’s chief executive officer at the time, hadn’t even known about the huge exposure. Since then, Citi has reported tens of billions of dollars in mortgage-related losses and the Federal Reserve has criticized the bank for exercising poor risk management oversight in a report to its board of directors. By yearend, Citi’s stock was trading in the low single digits-a stinging rebuke by investors.

“How could this happen?” you ask. My question is, “How could this happen again?” In December 1991, Institutional Investor magazine ran a cover story entitled “The Collapse of Citibank’s Credit Culture,” written by myself and a colleague, Ida Picker. The story detailed how in the late 1980s, an equally aggressive Citi had underwritten billions of dollars in commercial real estate and leveraged buyout loans-many of which had to be written-off when the U.S. economy slammed into a severe recession in the early 1990s. The day the story came out, Citi’s stock sank to just over $9 a share and there was widespread concern that the bank might fail.

Ironically, in the1970s Citi had been the first U.S. money center bank to write an in-house credit manual, a little green-jacketed book called the Credit Doctrine for Lending Officers. But few people at the bank still had the manual by the early 1990s-in fact, incredibly, some of the senior executives there first learned of its existence by reading our story! According to the Times, Citi now has a new chief risk officer who wants to learn from the subprime debacle and strengthen the bank’s risk management structure. “A change of culture is required at Citi,” this person was quoted as saying. I wish I could believe him, but we’ve heard this before.

Of course, Citigroup wasn’t the only Wall Street firm to behave as if risk was just a theoretical construct. Bear Stearns and Merrill Lynch were acquired by large banks in hastily arranged deals by the Federal Reserve after they got into trouble; Lehman Brothers was allowed to fail when it could no longer fund itself; and Goldman Sachs and Morgan Stanley, while still solvent, have sought the security of commercial bank charters.

How did we get to this point? Sadly, there’s plenty of blame to go around, whether it’s directed toward the Securities & Exchange Commission for relaxing the leverage restrictions on investment banks in the mid-1990s, the federal banking regulators who permitted depository institutions to flood the subprime mortgage market with cheap money on ridiculously easy terms, or Congress, which decided some years ago not to regulate the derivatives market.

Something has been missing in recent years-the firm hand of financial regulation. Some will say that asking for tougher regulation will invite overregulation, but it is appalling that the market excesses of the past decade have been allowed to send the global economy into a tailspin to the detriment of so many people. This is not an issue for community banks, which generally stay close to home and only make loans that they’re willing to hold on their balance sheets. The institutions that need to be reined in are the capital markets players that would use large amounts of debt to accumulate huge shares in highly complex securities and derivatives products that receive little regulatory scrutiny. Leverage, financial complexity, and inadequate regulation are a deadly combination, and we are living now with its consequences.

The author of Credit Doctrine was Henry Mueller, a career Citibanker who former CEO Walt Wriston asked to perform a postmortem after the bank had lost a bundle in the mid-1970s on real estate investment trusts. (A distressingly familiar theme at Citi, it seems.) Credit Doctrine contained all of Mueller’s accumulated wisdom, and while much of it would seem quaint in a modern era of credit default swaps and collateralized debt obligations, the underlying principals are just as sound today as they were three decades ago.

“If the lending officer…thinks raises and promotions come from booking credits, and if supervisors press for short-term, bottom line performance-letting lending officers sell too hard or even violate credit tenets-the quality of the portfolio will suffer,” Mueller wrote. “Memories are short when a salesman is in hot pursuit.”

Memories are short indeed, lasting little more than a decade if Citi’s experience is any guide. The capital markets need tougher oversight from Washington, to save the markets from themselves-and to save us from the market excesses that always seem to reoccur.