That Sounds SO Familiar

Originally posted August 2009. 

In their July 27, 2009 article titled “Citi in $100 Million Pay Clash” Wall Street Journal reporters Michael Siconolfi and Ann Davis share: “A top Citigroup Inc. trader is pressing the financial giant to honor a 2009 pay package that could total $100 million, setting the stage for a potential showdown between Citi and the government’s new pay czar. The trader, Andrew J. Hall, heads Citigroup’s energy-trading unit, Phibro LLC — a secretive operation, run from the site of a former Connecticut dairy farm that occasionally accounts for a disproportionate chunk of Citigroup income.”

Wait, haven’t we have heard something like this before? Quoting and paraphrasing from parts of the article: Phibro is a secretive operation, with huge compensation packages based on previously agreed contacts, where executives are permitted to operate with remarkable independence. It is a small core group that generates hundreds of millions of dollars in profit, and can boast a track record of making sizable, successful investment bets… that convinced company management to give more leeway for the unit to take on risk than it usually gives.

To us, that sounds much like AIG’s involvement in the development of collateralized debt obligations, which in 2008 culminated in the economic recession from which most of us (Mr. Hall being an obvious exception) are still suffering. But the fact that we haven’t learned from the AIG debacle shouldn’t surprise scholars and students of financial history.

We need only to look back a few years to 1995 and the demise of Barings Bank at the hands of “rogue trader” Nick Leeson, “whose unsupervised and unauthorized speculative trading on Singapore’s Singapore International Monetary Exchange (SIMEX) caused the spectacular collapse of Barings Bank, the United Kingdom’s oldest investment bank.” (From Wikipedia).

Or perhaps for more “ancient” history of Wall Street greed, we can go back to the 1980’s and the days of the “Junk Bond King”, Michael Milken, who, despite SEC suspicion of his activities, bamboozled Drexel management for years. Milken contributed a disproportionate share of Drexel’s profits and only later was it discovered that his activities were rife with illegal and/or unethical activities ranging from insider trading to stock parking to deceiving his clients. Company management seems to have been blissfully unaware of this owing at least in part to the fact that Milken relocated his team to the west coast where it operated with a great deal of autonomy. Although he was never officially found guilty of insider trading, Milken was banned from any involvement with the securities industry for life and paid hundreds of millions of dollars in fines and penalties relating to ill-gotten profits and compensation.

So could Phibro be the next AIG? Could Andrew Hall be the next Nick Leeson or Michael Mikin? And does anyone want to wait to find out if Citibank is again too big to fail? The underlying question is how leveraged is Phibro in their investment activities? If highly leveraged, and Hall makes the wrong bet, it could be a huge issue for Citi and another expensive burden for American taxpayers.

As we share in our blog “It’s Better to be on the Bus than Under It”, some weeks ago, Citigroup’s CEO announced that part of their new strategy will be to capitalize on the company’s strengths in the transaction processing arena with their Global Transaction Services unit (GTS). That commodity business might not deliver a powerful price-to-earning-ratio increase for Citigroup’s stock, but it certainly could be the foundation on which to build a new and stronger Citigroup. Its organizational structure and global reach makes this utilitarian and low-risk service an easy “win” for the giant bank. Lower-risk, lower-profit transactional services, rather than high-risk high-profit investment ventures appears to be the direction the Treasury Department is charting for large banks. The focus on compensation limits would likely result in the departure of high rollers like Hall or the spin-off of high-risk businesses like Phibro.

The Wall Street Journal article indicates that Hall has been garnering about 25 to 30 percent of the profits from the Phibro business for himself and his team. If essentially Hall is running a hedge fund, that compensation isn’t necessarily out of line. But for a TARP company nearly 1/3 owned by the American taxpayers, the risk that Hall might make a bad bet is simply too great. Essentially, the government is saying, if we can’t afford the possibility of your failure, we can’t afford your taking significant risks. So probably Citi won’t keep Phibro, or Hall won’t stay at Citi when the compensation opportunities evaporate.

As Grahall’s Greg Loehmann discussed on his blog “Risk Through Rose Colored Glasses” the Treasury Department is vigorously pursuing a program to regulate risk at TARP companies with compensation. As Loehmann says: “The Treasury’s effort draws the first line in what will likely be an ongoing battle. The result will lie somewhere between a steady, perhaps even stodgy, financial services industry and a more volatile version that rewards innovation. In our view, compensation is an effective tool for guiding behavior but also one that can come with many unintended consequences if there is not a deep understanding of the messages embedded in different compensation elements.”

Will this compensation-based approach to risk management be successful? As taxpayers and owners of these companies, we certainly hope so. Because without regulations we fear that Wall Street will continue to behave in ways that could excessively increase risk, secure in the expectation of a taxpayer bailout when the bet is lost. As taxpayers and TARP company owners we want to hold that bet.