Citigroup’s Hedge-Fund Returns Jump as Volcker Rule Looms

Citigroup Inc. (C), which took a $45 billion U.S. bailout after losses on subprime home loans, is boosting profits from a hedge fund that bets the bank’s money on mortgage debt -- a practice regulators plan to restrict.

Citigroup’s Mortgage/Credit Opportunity Fund climbed 16 percent in the first four months of 2011, almost doubling its pace last year, according to internal reports obtained by Bloomberg News. About 90 percent of the $395 million invested in the fund is the bank’s own capital, said a person with direct knowledge of the matter.

The fund, run by Rajesh Kumar, 41, has posted profits every year since it began in 2008, letting New York-based Citigroup benefit from an asset class that almost caused its collapse. The firm may seek new investors for the vehicle before regulators implement the Volcker rule, which Congress passed last year to force bank holding companies to cease bets with their own money.

“If the Volcker rule gets defined the way it was originally intended to be defined, then they’re probably going to need to divest their interest,” said Charles Whitehead, an associate professor of law at Cornell Law School in New York. “But why kill the goose before you have to?”

Citigroup, led by Chief Executive Officer Vikram Pandit, 54, himself a former hedge-fund manager, invested the initial $200 million when Kumar started the Mortgage/Credit fund. Kumar had joined the bank in 2008 from New York-based Halcyon Asset Management LLC, where he was a managing principal.

Profits Every Year

He oversees investments for the bank in commercial and residential mortgage bonds, including those tied to subprime loans. His team also bets company money on real estate investment trusts, government bonds and derivatives, internal reports show.

The fund returned 17 percent for the eight months of 2008 after its inception, 23 percent in 2009 and 26 percent last year, according to the documents, which include estimates for this year’s performance. Annualized, the 2011 return through April was about 47 percent.

“We remain bullish on the growth prospects of the overall U.S. economy and on the commercial real estate sector in particular,” Kumar wrote in a March report. “Mortgage product looks like a great relative value!”

Hedge funds worldwide have gained 3.5 percent this year through April, and those focused on fixed-income products rose 3.2 percent, according to May 11 estimates by researcher HedgeFund.net. Last year, the HFRI Weighted Composite Index, which tracks the performance of more than 2,000 hedge funds that manage at least $50 million, climbed 10 percent.

Patel, Franklin

Kumar’s hedge fund is part of Citi Capital Advisors, which oversees about $16 billion in so-called alternative funds, including private equity and venture capital funds, according to a person familiar with the matter. The division, led by Jonathan Dorfman, 49, and James O’Brien, 51, manages about $5 billion of Citigroup’s own money, said the person, who spoke on condition of anonymity because the figures aren’t public.

The Mortgage/Credit fund is outpacing Citigroup investment vehicles including the Event Driven Fund, managed by Mukesh Patel, a risk-arbitrage trader. That fund gained 7.1 percent this year through April, according to estimates in the internal reports. The Emerging Markets Special Opportunities Fund, managed by Mark Franklin, a former Salomon Smith Barney emerging-markets executive, is up 4.2 percent, the records show.

Fund Declines

The Global Macro Fund, managed by Kevin Bespolka, dropped 6.9 percent this year through April, according to the estimates. Managers of so-called macro funds seek to gain from global trends, and Bespolka’s fund uses “nimble” strategies to bet on government bond and currency markets, according to the bank’s website. Macro funds have gained 2.8 percent this year through April, data compiled by Bloomberg show.

The documents don’t list any of the funds’ sizes or indicate what share of their capital belongs to the bank. An April 2010 marketing brochure for the Event Driven Fund said that it “consists of only proprietary capital.”

Danielle Romero-Apsilos, a bank spokeswoman, declined to comment on the funds’ performance.

Citigroup slipped 30 cents to $41.24 at 9:40 a.m. in New York Stock Exchange composite trading. The stock is down 13 percent this year, after surging 43 percent last year.

The bank posted losses totaling almost $30 billion for 2008 and 2009, much of it linked to subprime mortgages. It repaid the taxpayer bailout last year, giving the Treasury Department a profit of about $12 billion, including dividends and proceeds from stock sales.

Kumar’s team separately managed two collateralized debt obligations tied to subprime bonds which were liquidated in 2008 and 2009 and “have lost most of their economic value,” according to the April 2010 brochure. CDOs package assets such as mortgage bonds into new securities with varying risks.

Goldman, Morgan Stanley (MS)

U.S. lawmakers passed the Volcker rule last year to curb risk-taking by banks that get federal assistance, such as deposit insurance. Regulators are set to release a final proposal in October for implementing the proprietary-trading ban, which is named after former Federal Reserve Chairman Paul Volcker. The Fed said in February that banks would generally have two years to comply once the rule takes effect.

Goldman Sachs Group Inc. (GS) is among firms that already have wound down some proprietary funds in advance of the Volcker ban. Morgan Stanley said in January it would turn one such unit into an independent firm by the end of 2012, while retaining an option to buy a preferred stake in the business. Both companies are based in New York.

“Citi wants to leave all the long-shot bets on its plate,” said Edward Kane, a finance professor at Boston College. “The riskier the investment, the more valuable it is to the shareholders of Citigroup.”

To contact the reporters on this story: Donal Griffin in New York at Dgriffin10@bloomberg.net;

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net.

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