Citi's Sleepless Nights

The bank faces lawsuits, fines, and closer scrutiny

As Citigroup's (C ) stock price plummeted 10% on July 22, Prince Alwaleed bin Talal, the Saudi Arabian royal who is the bank's largest shareholder, called Sanford I. Weill. Chief Executive Weill seemed to be taking the drop, which sliced $15 billion off Citi's market cap, in stride. "I guess you and I have both lost a little money this last week, your Highness," he joked. Alwaleed was less sanguine. "I think Sandy has to clarify the situation of Citibank much more aggressively," he told BusinessWeek.

Citigroup is facing its most serious crisis since Weill created the financial behemoth in 1998. Jack Grubman, the influential telecom analyst at Salomon Smith Barney, Citi's investment bank, is under investigation by the National Association of Securities Dealers and the New York State Attorney General's office. Salomon is also being sued over billions worth of bonds it underwrote for Enron Corp. and WorldCom Inc. Citi's corporate bank is accused by a Senate committee of using sham transactions to help Enron deceive investors. Its consumer bank is being grilled by the Federal Reserve over its subprime lending practices. And tough-minded banking regulators may wield widened powers to impose hefty debt write-downs and provisions on Citi.

There's no evidence the 69-year old Weill's position is in question. Alwaleed, who owns 6% of the stock, says he is "confident" that Weill will prevail. But a few former senior executives say the competitive culture that Weill has fostered inside the bank may be backfiring as investigators scrutinize the bank. At Citi, says one, employees "are expected to take risks--to produce handsome profits for which they will be rewarded. If not, they're gone." But a Citigroup spokeswoman rejects any implication that the culture encourages reckless behavior. "Sandy demands results, the first of which is maintaining and building the integrity of the firm," she says.

However, the bank, the U.S.'s biggest with nearly $1 trillion in assets, faces a potential triple whammy of big payouts over lawsuits, stiff fines imposed by regulators and legal authorities, and a regulatory crackdown. Some analysts speculate the sea of problems could now make it much more difficult for Weill to do what he loves best--dealmaking. Citi's pending acquisition of Golden State Bancorp, a key in its expansion in retail banking, "might be hung up," says David Hendler, an analyst with Credit Sights. "Regulators may feel that Citigroup has to slow down and apply better risk management, rather than continuing to build their empire." A Citigroup spokeswoman says, "The bank has every expectation the deal will close as planned."

Delays in getting regulatory clearance would be a severe blow to Citigroup. It has built a reputation as a powerhouse, in part because of its successful acquisitions. Salomon Smith Barney, which Weill put together over years, is now the premier underwriter of global debt and equity and rakes in far more banking fees than rivals. As it built up its underwriting prowess, Salomon was helped by Grubman's role as the Pied Piper of telecom.

Now, the NASD is investigating Grubman's coverage of Winstar Communications, and has made a "preliminary determination" that violations occurred. On July 24, Rep. Paul E. Kanjorski (D-Pa.) requested the House Committee of Financial Services to subpoena Salomon for information on initial public offering allocation to WorldCom executives. So far the bank is behind Grubman. But it has also adopted some reforms designed to keep analysts and bankers separate.

More serious damage could come from Citigroup's links with Enron. On July 23, Carl Levin (D-Mich.), chairman of the Senate Permanent Subcommittee on Investigations, said that "Citicorp knew what Enron was doing, assisted Enron in the deceptions, and profited from their actions." At issue is $4.8 billion in transactions that Citigroup arranged for Enron. The financings known as pre-pays were really disguised bank loans that helped Enron make its numbers, the committee alleges. If both the Citi deals and similar transactions by J.P. Morgan Chase & Co. had been put on Enron's balance sheet, its debt ratio would have soared to 96.2% from 69.2%.

Citigroup's liability could hinge on whether it knew it was doing something wrong. David Bushnell, managing director at Citigroup's Global Corporate & Investment Bank, defended the transactions. "We believed that Enron was making good-faith accounting judgments that were reviewed by Arthur Andersen, which was then the world's premier auditing firm in this sector," said Bushnell. "Enron was not the company we thought it was." But one e-mail obtained by investigators seems to indicate that bankers panicked when an investor started asking questions about one such transaction, saying "We need to shut this down."

New guidance from regulators could cut earnings at Citi's consumer-lending arm, its most profitable unit this year. On July 22, regulators warned banks--especially those heavily into subprime, or high-risk, credit-card lending--to tighten their procedures, create larger reserves, and manage risk better. Citigroup has the largest card portfolio in the world, with 108 million accounts.

Equally threatening to Citi is a torrent of litigation. Bondholders who bought more than $11 billion in WorldCom debt last May are suing underwriters Citigroup and J.P. Morgan for lack of due diligence. WorldCom said in June that it had found a $3.8 billion accounting fraud. Both banks say their underwriting was proper. But plaintiffs' lawyers may have a case. In a 1968 ruling, Escott v. BarChris Construction Corp., a judge said that bond underwriters should have known BarChris was faking some numbers because internal documents showed the company was having trouble getting customers to pay on time. Citi is already named in Enron-related suits brought by pension holders. They could be followed by insurers, which bought securities designed by Citi, to hedge $1.4 billion of its Enron exposure.

Now the Gramm-Leach-Bliley Act of 1999, which repealed the Depression-era prohibition against combining commercial and investment banking--and was tailor-made for Citi--could be used against the bank. The law requires diversified financial companies to be "well-managed," not just "well-capitalized." On July 18, federal regulators are limiting the activities of Pittsburgh's PNC Financial Services on those grounds. Institutions most at risk of scrutiny are those involved in complicated financing such as special purpose entities and pre-pay deals, both of which Citi arranged for Enron, says Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc., a Washington bank consultancy.

Despite Citi's problems, Alwaleed sees a silver lining. "This is not only the most profitable bank in the world, but it is now the cheapest," he says. That's fine--provided the heavy discount on the stock isn't a warning of worse to come.

By Heather Timmons in New York, with Laura Cohn and Mike McNamee in Washington, and John Rossant in Paris

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