Is Citigroup's Sandy losing focus?

On July 29, relieved investors listened to the affidavit of Citigroup chairman Sanford Weill, who said he had no personal knowledge of offshore units at the heart of a US Senate probe involving Enron. His reward? A 10% rally in Citi shares, which had fallen 25% days earlier as the congressional probe involving Citibank's role in the Enron scandal heated up. On July 24, and again on July 29, in an affidavit by Barbara Yastine, Citigroup chief financial officer of corporate and investment banking, Citigroup said it did nothing improper. The sell-off, which pushed the shares just shy of the last low in October 1998 during the Russian crisis, took place as congressional investigators grilled Citigroup and JP Morgan Chase about the role they played in devising special purpose entities that allegedly helped Enron to hide millions of dollars in debt.

Investors sent a clear message in the rally: they are rooting for a Citi vindication because the bank has been throwing off returns like a golden goose since the merger of Travelers Group and Citicorp in 1998. Many see this as a bad-luck phase and continue to intone the mantra: "It's the fundamentals, stupid". And the fundamentals have been impressive. Even after September 11, the Enron debacle, the crisis in Argentina and a recession, the bank churned out $4bn in earnings for the second quarter - a 15% increase over the same period for the previous year. Since its merger, the bank has returned more than 150% to shareholders while its return on equity stands at around 19% compared with an industry average of 16%. The bank, with $1000bn in assets, towers over its peers and has pockets deeper than the Grand Canyon.

It is no wonder that Sandy Weill, 69, has achieved deification in the marketplace. In July, with Enron apparently behind him, Chief Executive magazine honoured him as the chief executive of the year. In May, he was given Columbia University's distinguished Leader of the Year Award in Business. He is one of the most highly paid chief executives in the marketplace; his total compensation was around $28m in 2001.

In contrast, a few months ago, his colleagues at JP Morgan Chase - Enron's other key banker - were writhing in the public glare. Although Citigroup was being investigated alongside JP Morgan for its role in Enron's financing troubles, it kicked up its heels. After all, hardly anyone seemed to care. "Everyone had this awe for Citi, even as they were eating JPM's lunch," says James Mitchell, senior analyst at Putnam Lovell & Thornton.

Now Citigroup's sacrosanct reputation is on the line. Even more worrisome, regulators and politicians are in an ugly mood as impoverished investors bay for blood amid a watershed of corporate scandals. Bankers worry about what lawmakers on Capitol Hill are planning during summer recess. While reputations can be rebuilt by an earnings powerhouse such as Citi, the wrath of politicians and regulators is another matter - especially when constituents are protesting. On this score, most admit they are working in the dark. "It's not possible to quantify the regulatory implications," says Diane Glossman, senior bank analyst and managing director at UBS Warburg. "My estimates don't assume there will be lasting damage. But I'd be lying if I said I knew what day these issues will be clear and we can get back to worrying about the more easily forecasted events." These uncertainties have prompted a raft of recent earnings downgrades for the bank.

The black box

Lehman Brothers analyst Brock Vandervliet calls the situation "a black box". He says he is concerned that punitive legislative and regulatory actions might make it more difficult for Citigroup to pursue aspects of its business in the future - especially when it comes to accounting for off-balance sheet items. On the most basic level, structured finance allows banks that are card issuers to move credit card assets off their balance sheet in the form of securitisation. On the more complicated side of the equation are companies like Enron that use special purpose vehicles (SPVs) to shovel debt off the balance sheet into separately run entities. Enron used numerous SPVs with code names like Raptor that sounded straight from a science-fiction film.

The complexity of these transactions can be mind-numbingly difficult to decode, which is one of the reasons why they can seem deceptive. Some argue that this is precisely what the architects of such vehicles intend - dissimilitude. That might be enough to rouse law makers, even if they cannot ultimately prove Citigroup, JP Morgan or Enron broke the law.

"The risk is politicians are gearing up for a fall election and might do something in terms of legislative initiative that could, for instance, define derivatives so broadly you are cutting off your nose to spite your face," says Mr Vandervliet. Or, banks could be forced to separate research from investment banking. "That would be a material problem for the industry," he says.

For a legislative freedom fighter like Sandy Weill, the possibility of new restrictive legislation would be galling. It was his deal - the $70bn merger of Travelers and Citicorp in 1998 - that demolished what was left of the 1933 Glass-Steagall Act. That legislation prevented commercial banks from owning brokerages. No-one thinks the Act will be revived but the thought of legislators and regulators clamping down in smaller ways has the market on tenterhooks.

A tarnished crown

For the first time in years, the crown of Mr Weill - dubbed "the king of capital" in a recent biography - looks askew.

He has experienced the fulcrum of success and had an uncanny knack for attracting top-flight names to manage that success with him. While other bank boards and management committees have the odd well-known name to boast about, Mr Weill's executive committee and board looks something like a Who's Who from political and corporate circles. His board boasts former CIA head John Deutch, AT&T chairman Michael Armstrong and former US president Gerald Ford, who serves as honorary director. His executive committee includes the illustrious former US Treasury secretary Robert Rubin, former first deputy managing director of the International Monetary Fund (IMF) Stanley Fischer and the banking industry's Meister of Latin American debt workouts, Bill Rhodes.

Despite Mr Weill's reputation for shouting at subordinates when problems occur, he inspires a rare depth of loyalty. "Sandy is a big, charismatic leader who believes in empowering his people. He's unique," says one of his executives. This sentiment is also expressed by others in the bank.

Mr Weill's inner circle is a close-knit crew of some seven senior executives who meet once a week for two hours. The broader management team meets once a month for a full day at the bank's corporate retreat in Armonk, New York. Mr Weill's ability to command loyalty, while maintaining ruthless control over the bottom line, is one of the reasons Citigroup has performed so well. This performance has held the market in thrall during a honeymoon that has endured four years. Now, judging by the bank's 38% share price drop since January, that honeymoon is over. Some are starting to wonder, once again, if a company of Citigroup's size and diversity is too cumbersome to control. Although the group's diversification in consumer finance, banking, brokerage, credit cards and wealth management has been an earnings boon, it is clear that such diversity can bite back.

No escape

"We all underestimated that Citigroup is diverse and that, while that helps it to deliver, it gets it into every scandal - it cannot escape anything," says Putnam Lovell's Mr Mitchell. Problems have appeared in consumer finance, investment banking, corporate finance and the emerging markets - in particular the corporate bankruptcies that have littered the stock market this year. Citigroup, as the country's third largest lender, is involved in most of these deals.

"The notion of the invincibility of Sandy Weill as a melder of different businesses into a cogent whole and someone who can maintain effective control over the parts is a real issue here," says Samuel Hayes, professor of investment banking emeritus at Harvard University. "I think his image as a miracle worker was overdone."

Mr Hayes believes Citigroup will be forced to scale back its operations in time, ultimately becoming a smaller bank than it is today. "It will take years and years and a great deal of restructuring and spin-offs to make it into an operating company," he predicts.

Financial obfuscation

Citigroup could use Mr Weill's magic touch right now. Congressional investigators testified in late July that Citi and JP Morgan Chase helped several companies, not just Enron, to set up sham transactions to obscure their finances. Regarding Enron, congressional investigators have alleged that Citigroup and JP Morgan Chase gave Enron $8.5bn in loans disguised as commodity trades through offshore shell companies, including Delta Energy. Citigroup said it does not control Delta, which was established in 1993 as a special purpose entity with the intent of keeping it legally separate from the group.

Elsewhere, Citigroup is busy defending its investment bank Salomon Smith Barney, which is under scrutiny for its role in the telecoms industry. At the heart of the controversy is Salomon's former telecom star analyst-come-rainmaker Jack Grubman, who had close ties to companies that are now bankrupt. A prominent part of the probe revolves around beleaguered WorldCom, which earned Salomon and Mr Grubman millions of dollars in investment banking fees. Mr Grubman continued to recommend the stock even as it plunged.

The investigation has come across snags, though, due in part to an absence of e-mails that might back up allegations that Mr Grubman was acting dishonestly. The Wall Street Journal has reported that regulators may fine six securities firms, including Citigroup's Salomon Smith Barney, for allegedly failing to keep and produce e-mails in pending investigations of Wall Street abuses.

Salomon is one of Citigroup's crown jewels, rolled into the corporate and investment banking group, which contributes some 24% of Citigroup's earnings. According to Thomson Financial, Salomon Smith Barney earned $1.3bn in fees for debt and equity offerings in the first half of this year, 60% more than its nearest competitor.

Even Citi's vaunted consumer finance business, CitiFinancial, which is the largest in the country, is encountering difficulties. The Federal Trade Commission has alleged that CitiFinancial has used deceptive consumer practices. Among the people to whom CitiFinancial lends money are lower-income individuals with sub-prime loans. The bank is defending itself against accusations that it has used predatory methods, including frequent refinancings, to generate more fees. CitiFinancial is one of the bank's important growth generators. In the second quarter this year, the unit's profit increased 19% to $326m from a year earlier. That is roughly 8% of Citigroup's overall profit.

Citigroup, meanwhile, has other worries simmering in the emerging markets, specifically Brazil. Although the Latin American country has just received a $30bn bailout package, the markets are far from stable. If the situation deteriorates and the government defaults, that would be a problem for Citigroup, which has $3bn in Brazilian government debt outstanding. Brazil's troubles are also a fresh reminder that not long ago, Citigroup wrote off some $1bn in losses because of Argentina's default.

Taking the high ground

On July 12, a clearly concerned Mr Weill dispatched a letter to the Securities and Exchange Commission, the New York Stock Exchange and the National Association of Securities Dealers calling for changes in the industry. He suggested regulators prohibit analysts from attending any meeting with investment bankers who were soliciting business from public companies. He said investment bankers should not be allowed any input in determining the compensation of research analysts.

Cynics say he is seizing the high ground to head off a legislative blow or regulatory fine.

Whatever the case, Mr Weill is on a roll. On August 7, Citigroup unveiled a raft of corporate-governance initiatives, including a move to expense all stock options. That move will cut earnings by three cents a share in 2003 when the plan becomes effective. Citigroup also announced it would require companies for which it extends financings to disclose more information to investors. In a written statement, Mr Weill said: "If a company does not agree to record a material financing as debt on its balance sheet, Citigroup will only execute the transaction if the company agrees to publicly disclose its impact to investors." This is classic Sandy Weill - seizing the initiative before someone else lands a punch. It has worked before; whether it will work this time is anyone's guess. Few people are worried about Citigroup being hurt financially because it has plenty of cash to deal with any fines it might have to pay. But some do wonder if Citigroup will be forced to undergo yet another change in its management or structure.

The reinventions

In early June, Mr Weill put the finishing touches to the bank's latest management reorganisation, just a few months after it absorbed large losses in Argentina and Enron. The move, which intensifies the bank's overseas focus under a new international division headed by Sir Deryck Maughan, was greeted in the market with tepid applause. That was the bank's fourth management change in four years and the second time that president Bob Willumstad's duties had been changed in about five months.

The first big management change came in 1999 when heir-apparent Jamie Dimon, a long-time protégé of Mr Weill, was fired. In 2000, another industry personality, co- chairman John Reed, was forced out of the group. In February last year, Mr Weill added 24 executives to the core management team to make it 44 (the next biggest bank, JP Morgan Chase, has a management committee of 14 executives).

Critics say that Citigroup's June reorganisation underscores how complicated Citi's empire is and how tough it has been to control. Being a conglomerate is a dangerous identity to have these days. Well before recent events, the Citigroup management was feeling uneasy with its supermarket image. Last year, the concept of one-stop shopping was all the rage and no institution did it better than Citi, the author of the model. But when the Enron debacle began, the model became a red flag waving in the face of regulators and politicians.

The matrix is back

In recent months, Citi has dusted off an old business model known as the matrix. The matrix is a decentralised system suited to large companies traditionally in the industrial sector.

"This gets us away from the idea that we are trying to be all things to all people - a financial supermarket," Citigroup chief financial officer Todd Thompson said in an interview with The Banker. "We're trying to focus where we have strong growth. We're big and have a lot of products and appear to be complicated. So the easiest thing is to say we're a one-stop shop. I don't think that's accurate," he says.

The changes fine-tune management in a structure that looks something like a grid of nine product areas and six geographic regions, with an emphasis on the international business. The bank has eliminated its emerging markets division and given that group's head, Victor Menezes, the new job of managing senior client relations and contacts with governments regulators. That has worried some analysts, who question Citi's timing in deciding to fold emerging markets into a bigger group when it churns out 21% of the bank's core income. "We feel uncertain about the combination of problems in emerging markets, the elimination of emerging markets as a business line and new oversight of risk management all at the same time," says Michael Mayo, senior analyst of Prudential Securities in a Citi report.

Citi bankers say the streamlined international structure should give them better leverage. "We're reinforcing the matrix. It's a realisation that we were leaving some things on the table and not acting as well for the interests of our customers because we were too silo-oriented," says Sir Win Bischoff, chairman of Citigroup Europe. "We weren't being sensitive enough, say, to individual regions like the Italian market because we were coming at it too American or global in perspective." He adds: "The main thing is to give the international organisation a view of what's necessary for that country. We were paying a bit more lipservice to this than taking constructive steps."

Local managers in Europe played a part in the latest revamp, he says. "The latest change - the creation of the international group - is something that the next management group down had repeatedly said needed to be done. So this is responding to our people in the field."

That is presumably how a matrix works. But sustaining such co-operation can be tough, says one former Citi executive who has experienced a case of matrix dŽjˆ vu. "The matrix is back," says an amused George Davis, who ran Citicorp's corporate and investment banking group for North America before leaving in 1990. He now runs the consulting firm Scarborough Partners Inc. "The matrix came into my life at the end of the 1960s when Citi management discovered this management tool. But, ultimately, it wasn't that terrific," he recalls. He says the matrix "optimises resources" by forcing people throughout a company to work closely together. "The problem is that it's tough because everyone has to co-operate and no-one's clearly in charge, which works against human nature," he says.

Healthy scepticism

For some analysts, human nature means a healthy dose of scepticism. "Citi is cheap relative to what it has been but then it might be cheap and stay cheap," one analyst says. "Are we at a turning point? The question is: are we at the bottom? We could have another WorldCom or Enron every quarter."

The share price, meanwhile, points to other problems: a lower share price means acquisitions will be tougher to afford. Last year, Citigroup spent $15bn on acquisitions, including Grupo Financiero Banamex-Accival, Mexico's second largest bank, and Taihei Financial in Japan. At home, Mr Weill paid $1.6bn for European American Bank. A year earlier, he snapped up Dallas-based Associates First Capital for $30bn, making the bank the largest originator of home equity loans. This year, Citi bought San Francisco-based Golden State Bank for $5.8bn, using cash from the spin-off of Travelers Property Casualty.

Citigroup and much of the market are hoping that Mr Weill will retain his free reign. But it is difficult to foresee when business will return to normal. "I think the argument now is how effective banks are going to be in pursuing the new mandates they have been given," says Professor Hayes. "It's very hard to run an organisation with so many different businesses, where intricacies are so complex that the potential for mis-steps are large."

Everyone knew mis-steps were possible but now that Citi has stumbled, investors are proceeding with less abandon. As the markets have learned during the past few months, no company is invincible. Through the pain, die-hard Citigroup fans have learned, as US writer Mark Twain said many years ago: "Denial ain't just a river in Egypt."