“If it went wrong, we were in it, we were bigger in it and we were slower to react,” said one senior Citigroup executive summing up Monday’s profit warning.
The surprise was not just that the 60 per cent forecast fall in third-quarter earnings was bigger than expected, but that the problems were spread so widely across the group.
Within Citigroup’s investment bank there were $1.4bn of writedowns on leveraged loan commitments, $1bn of net writedowns on mortgage-backed securities, $250m of writedowns on collateralised loan obligations and $600m of other credit trading losses. Moreover, Gary Crittenden, chief financial officer, said that the performance of its markets and banking business was “below expectations – even taking in account turbulent market conditions”.
At the same time, Citi’s consumer business, which is supposed to cushion the swings in its more volatile capital markets activities, also disappointed.
Citi had signalled that higher credit costs were inevitable as the very favourable recent credit environment reverted to more normal levels.
But the $2.6bn rise in credit costs in the consumer arm was higher than expected, largely due to a gloomy view of the outlook for US mortgages.
Credit costs were also significantly higher outside the US, with continued problems at its consumer finance business in Japan.
Chuck Prince, chief executive, has stressed the importance of rekindling growth in the US consumer business, particularly the huge cards operation.
So analysts felt it particularly disappointing that Citi predicted that US consumer revenues would be flat in the quarter – partly due to higher funding costs in cards, which stemmed from the problems in the commercial paper market.
The $3.3bn of losses and writedowns in Citi’s markets and banking business are more in line with those announced on Monday by UBS and forecast by analysts for Merrill Lynch, than those recently reported by the four Wall Street banks with August quarter-end.
Merrill Lynch is widely expected to record large writedowns on leveraged loan commitments, CDO holdings and other mortgage-related positions.
One common factor appears to be that Citi, Merrill and UBS all expanded aggressively into structured products in the past couple of years.
Last summer, Citigroup hired Michael Raynes from Deutsche Bank, a leader in the field, to build its structured credit business.
The biggest losses came in the business that accumulated pools of mortgages or mortgage-backed securities (mostly subprime) to bundle them into collateralised debt obligations for sale to investors.
Citi said that at the start of the year it had $24bn of secured subprime exposure in its lending and structuring business. That number was $13bn at the end of June, and declined slightly during the third quarter.
“Despite our aggressive efforts this year to work these positions down, and to put in place appropriate hedges, we were still holding mortgage assets in our warehouse, or holding undistributed tranches of CDOs, when the market dislocated,” said Mr Crittenden.
The net writedown of these after hedges was $1bn with a further $250m from similar losses on holdings of leveraged loans that were to be turned into collateralised loan obligations. In addition, Citi suffered losses of a further $600m in credit trading. “What started as a problem in the subprime and CDO markets rapidly spread to affect the pricing on corporate bonds, loans, and credit default swaps.”
This is a particular setback for what is one of Wall Street’s premier credit trading operations, built on the foundation of the bond trading prowess of Salomon Brothers.
The operation is run by a tight-knit team of executives many of whom have worked together for 20 years.
Citi’s markets business is headed by Tom Maheras, who started as a corporate bond trader 23 years ago, while the fixed income arm has three co-heads, Randy Barker, Geoffrey Coley and Paco Ybarra.
Insiders say that in spite of the problems only a couple of low-level executives have left. This contrasts with Morgan Stanley, where two senior credit traders were ousted following losses in structured product trading.
Michael Klein, who heads Citi’s banking arm, has been using its balance sheet aggressively to win business from private equity firms.
The price was a $1.4bn writedown on its leveraged loan commitments, although some insiders believe much of those losses could come back thanks to a recovery in the market and renegotiation of some deals,