Citi's Leadership Challenge

Chairman Rubin has his work cut out for him as he sets out to find a permanent CEO up to the task of leading Citi back to prosperity

Who should lead Citigroup? It's a tough question.

Even Robert Rubin, the newly appointed Citigroup (C) chairman and former Treasury Secretary, stumbled a bit during a conference call with analysts on Nov. 5 when asked what qualities the company's next chief executive should possess. "It's a bit intangible," said Rubin, who is leading the search for a permanent successor to CEO Charles Prince III. "It has to be somebody who can drive the vision, drive the execution."

Rubin, a former co-chairman of Goldman Sachs (GS), said Citi's next CEO must be able to lead a large organization effectively and relate to the globalization of the institution. "That takes a very special kind of leadership," Rubin said.

The Short List

One frequently mentioned candidate (, 11/2/07) is John Thain, the chief executive of NYSE Euronext (NYX) and a former president of Goldman Sachs. Another possibility is Gary Crittenden, Citi's chief financial officer. He has the respect of many investors, including Charles Smith, lead manager at the Fort Pitt Capital Total Return Fund, who believes Crittenden would be "a stabilizing force." Win Bischoff is now interim CEO after succeeding Prince at an emergency board meeting on Nov. 4 (, 11/5/07). But the 66-year-old head of Citi Europe is not considered a likely candidate for the permanent job.

There have even been calls for the return of Sanford Weill, the company's controversial former CEO and chairman. On Nov. 5, the largest individual investor in the company, Saudi Prince Alwaleed bin Talal, told CNBC (GE) Weill would be a good temporary choice to establish stability. And he's not the only one. "They should issue a recall on Sandy Weill" as chairman, says Mario Gabelli, the activist mutual fund manager of Gabelli Funds. "Challenges like this require someone with gray hair."

A Matter of Accounting

Any candidate would have to think long and hard about taking on the task of cleaning up Citi (, 11/1/07). On Monday, Rubin and other top executives told investors about yet another recalculation of its third-quarter losses and a staggering charge for the upcoming quarter. The company said it will take writedowns of $8 billion to $11 billion in the fourth quarter, after the $6.5 billion in writedowns it took in the third quarter. Citi also said it is lowering its previously stated third-quarter profit of $2.38 billion by $166 million, to $2.21 billion. The change reflected a more up-to-date view of the declining value of fixed-income assets.

But the uncertainty may be more unsettling than the specific figures. Rubin and Crittenden presided over a call with analysts that made it clearer than ever that Citi doesn't know when or where the problems will end. Because the credit markets are illiquid, with some securities not trading at all, it's impossible to know the full extent of Citi's losses or whether more writedowns are on the way. Rubin and Crittenden made that point crystal clear: "There's no way, I think, anyone can give you assurance of how things are going to move," said Crittenden. "We've taken what I think is a reasonable stab."

So far, the losses are a matter of accounting. The company's troubled investment pools, with subprime debt exposure, have lost market value, forcing the writedowns. They are still generating cash, although the company warned cash losses are possible. That could happen if defaults in the residential mortgage market or other troubled areas rise from current levels. The company also warned that it faces an unnamed risk from certain "secondary and tertiary" exposures in the credit markets. The current losses are related to "direct exposures" only. The company declined to say how large the secondary and tertiary exposures could be.

Cloudy Forecasts

Citi said it expects its capital ratios, which have dropped below their targeted range, to return to where they should be by the middle of 2008, six months later than originally forecast. "The loss materially eats into Citigroup's capital, which is already below the bank's targeted level," says Ganesh Rathnam, an analyst with Morningstar (MORN). He believes the bank would be forced to reduce the size of its balance sheet to boost capital levels, "substantially affecting its earnings power over the next two to three years."

The hour-long call unnerved Citigroup investors and the broader market. Citi shares closed at $35.90 on Monday, off 4.9% for the day. They are down 37% from a 52-week high of $57 in early January. The Citi news was a factor on Nov. 5 as the Standard & Poor's 500-stock index fell (, 11/5/07) 7.57 points, or 0.5%, to 1502.08.

There is speculation that Citi could be forced to sell higher-quality assets, such as those in its real estate or credit-card portfolio, to boost its capital level. Analyst Meredith Whitney of CIBC World Markets says no market for the lower-quality assets currently exists. She remains skeptical that Citi will be able to maintain its dividend, although the company said Nov. 5 it has no plans to cut it.

Some investors believe Citi could be forced to take more writedowns, if the prices of collateralized debt obligations continue to fall. "We estimate that Citi has written down about one quarter of its CDO [collateralized debt obligation] exposure, which might not be enough," says analyst Mike Mayo of Deutsche Bank (DB). "Information risk is huge because we don't know where the $55 billion of exposure has been written down," he adds.

The Advantage of Liquidity

Investors say Citi has plenty of liquidity to carry it through the storm, at least for now. "Citi's earnings are impaired for the next 18 months to two years, but it's an earnings problem, not a balance sheet problem yet. They've got plenty of liquid assets to sell if they need to," says Fort Pitt's Smith.

Over the longer run, say two or three years, Citi's writedowns could actually be reduced. The current writedowns assume that the price of triple-A rated homes will fall 20%, according to Smith. They have been marked down to 80¢ on the dollar. Those writedowns are driven by decreases in the mortgage derivatives indexes, not actual home prices. "They've taken a bit of an overshoot going to 80¢ on triple-A-rated mortgages," Smith says. He thinks the write-offs could be revised to 4¢ to 5¢ on the dollar over the next few years, which is why he owns the stock.

Some bears, however, expect a true catastrophe in the mortgage market. Bill Gross, the chief investment officer of Pacific Investment Management, told CNBC on Monday morning that he expects 25% of the U.S.'s $1 trillion in subprime mortgages and similar mortgages to default, with banks such as Citi and Merrill Lynch (MER) taking the hit. Gross said the Federal Reserve needs to keep cutting the federal funds rate and the rate on conventional mortgages needs to drop to 5% to 5.5%. Otherwise, homeowners with adjustable-rate mortgages will be hit with higher rates, driving many into default.

The problem is the Fed suggested in October that it's finished lowering rates for now. It's worried that higher rates will drive up inflation or reinflate the housing bubble, analysts say. The Fed could face a real conundrum: lowering rates to bail out banks such as Citi or Merrill, or risking a systemic problem in the financial system to keep inflation from returning.

Missed Opportunity

It's clear that Prince and Citi management had no appreciation for the depth of the credit market's problems. Crittenden said the company could have hedged against a decline in the value of its CDOs back in February. But by the time they realized their mistake, in September, it was too late to buy a hedge at a reasonable rate. Citi management never saw the problems in the subprime credit market coming.

The firm's next CEO will have his work cut out for him. He will have to grapple with how to extricate the company from its current crisis—and put the company on footing stable enough to permit it to capitalize on the opportunities ahead.

Rubin promised that the search for a new CEO will be quick. One thing is clear: He doesn't want the chief executive job himself. At 69, he's more interested in being an adviser than a chief executive.

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