Did Citi Get a Sweet Deal?

In the run-up to the global financial collapse, Citigroup’s bankers worked feverishly to create complex securities. In just one year, 2007, Citi marketed more than $20 billion worth of deals backed by home mortgages to investors around the world, most of which failed spectacularly. Subsequent lawsuits and investigations turned up evidence that the bank knew that some of the products were low quality and, in some instances, had even bet they would fail.

The bank says it has settled all of its potential liability to a key regulator — the Securities and Exchange Commission — with a $285 million payment that covers a single transaction, Class V Funding III. ProPublica first raised questions about the deal in August 2010. In announcing a case, the SEC said it had identified one low-level employee, Brian Stoker, as responsible for the bank’s misconduct.

It made no mention of the dozens of similar collateralized debt obligations, or CDOs, Citi sold to investors before the crash.

A bank spokesman said the SEC would not be examining any of those deals. “This means that the SEC has completed its CDO investigation(s) of Citi,’’ the spokesman asserted in an e mail.

“The $285 million settlement resolves only the Class V Funding III CDO, and we will not hesitate to bring further charges where we determine that there has been unlawful conduct,” an SEC spokesman said.

Did Citi get a sweet deal? Some observers think so.

“Citibank arranged countless CDOs that were built to fail, but the SEC apparently limited its case to a single CDO where they had particularly vivid and powerful proof,” says Stephen Ascher, a securities litigator at Jenner & Block, which has sued Citibank on various structured finance transactions.

“This represents extreme caution, at best — and a failure to grapple with the magnitude and harmfulness of the misconduct, at worst.”

ProPublica has been investigating the practices of the investment banks in the lead-up to the financial crisis for three years. Our research found a number of Citi CDOs similar to the deal featured in the SEC’s Class V complaint, and more information on Citi’s CDO business has emerged in lawsuits and subsequent investigations. Responsibility for these practices did not begin or end with Mr. Stoker. Among the questions still unanswered: How much did Stoker’s immediate bosses know? What did the heads of Citigroup’s CDO business, fixed income business and trading businesses know about Citi’s CDO dealings?

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In the settlement announced this week, the SEC charged Citigroup with misleading its clients in the $1 billion Class V Funding III. The regulator said that the bank failed to disclose that it, rather than a supposedly independent collateral manager, had played a key role in choosing the assets in the deal when the bank marketed it to clients. Citigroup also failed to tell its clients that it retained a short position, or bet against, the CDO it created and sold. In addition to the $285 million fine, the SEC also charged Credit Suisse Alternative Capital, which was supposed to choose the assets that went into the CDO, and a low-level executive at that firm, with securities law violations.

Stoker becomes only the second investment banker after Goldman Sachs’ Fabrice “Fabulous Fab” Tourre to be charged by the SEC in conjunction with the business of creating CDOs, which were at the heart of the financial collapse in the fall of 2008. According to the SEC, Stoker played a leading role in structuring Class V Funding III. Stoker declined to comment. His lawyer has said he is fighting the charges.

The SEC complaint shows that Stoker was regularly communicating with other Citi executives about his actions. One top Citi executive coaches employees in an email that Credit Suisse should tell potential buyers of Class V about how it decided to purchase the assets, even though Citi, not Credit Suisse, was making the calls.

In October 2006, people from Citi’s trading desk approached Stoker about shorting deals that Citi arranged. Later, in Nov 3, 2006, Stoker’s immediate boss inquired about Class V Funding III. Stoker told his boss that he hoped the deal would go through. He wrote that the Citi trading group had taken a position in the deal. Citi’s trading desk was shorting Class V Funding III, betting that its value would fall. Stoker noted that Citi shouldn’t tell Credit Suisse officials what was going on, and that Credit Suisse had agreed to be the manager of the CDO “even though they don’t get to pick the assets.’’ Less than two weeks later, this executive pressed Stoker to make sure that their group at Citi got “credit” for the profits on the short.

This Citi official, unnamed in the complaint, was not charged by the SEC.

If Class V Funding III was some outlier, the SEC’s action might make more sense. But it wasn’t. Citigroup’s CDO operation churned out at least 18 CDOs around the same period. Often they were large CDOs, created with credit default swaps, effectively a bet that a given bond will rise or fall. Most of the CDOs included recycled Citi assets that the bank couldn’t sell. By purchasing pieces of its older deals, Citigroup could complete deals and keep the prices for CDO assets higher than they otherwise would be. Some investors helped picked the assets and then bet against them, facts that Citi didn’t clearly disclose to other investors in the deals.

Closing the book on Citi’s CDO business means the public may never know the true story of Citigroup’s, and Wall Street’s, actions during the financial crisis. One of the largest victims of the CDOs was the bond insurer Ambac. The now-bankrupt firm settled with Citi in 2010, long before it got to the root of the problems with securities Citi convinced it to insure. A shareholder class action lawsuit that is wending its way through the courts has the potential to reveal some details, but often such cases are settled with evidence then sealed from public view.

Among the unresolved questions: What was Citigroup’s role in a series of deals involving Magnetar, an Illinois-based hedge fund that invested in small portions of CDOs and then made big bets against them? Our investigation showed that Citi put together at least 5 Magnetar CDOs worth $6.5 billion. Did Citi mislead the investors who lost big on these deals?

Here are some other questions about Citi CDOs created around the time of Class V Funding III:

• 888 Tactical Fund. A February 2007, $1 billion deal, it had a significant portion of other Citi deals in it. Did the bank have influence over the selection of the assets, as it did in Class V Funding III?
  
• Adams Square Funding II. A $1 billion March 2007 deal. The pitch-book to clients for Class V Funding III was adapted almost wholesale from this deal, according to the SEC complaint. Was Citigroup shorting this deal, or adding assets that were selected by others to short the deal? And was that adequately disclosed to clients?
  
• Ridgeway Court Funding II. Completed in June 2007, this $3 billion deal contained a mysterious $750 million position in a CDO index. Experts believe that such positions were included for the purposes of shorting the market. Did Citi disclose why it included these assets to the investors in this CDO? As much as 30 percent of the assets in the deal were from unsold Citi CDOs. Was this a dumping ground for decaying assets the bank could not unload, as a lawsuit by Ambac, which was settled, charged?
  
• Armitage. This $3 billion March 2007 CDO looked a lot like Ridgeway II. It had a large portion of other CDOs, much of which came from other Citi deals, including $260 million from Adams Square Funding II. Did Citi adequately disclose to investors what they were buying?
  
• Class V Funding IV. A $2 billion June 2007 deal, Citi appears to have done this directly with Ambac. The SEC complaint about Class V Funding III makes it clear that Ambac was unaware of Citi’s position in that deal. Did the bank disclose more to Ambac in this deal?
  
• Octonion. This $1 billion March 2007 CDO bought some of Adams Square Funding II. Adams Square II bought a piece of Octonion. A third CDO, Class V Funding III, also bought some of Octonion. Octonion, in turn, bought a piece of Class V Funding III. How did Citi and the collateral managers involved in these deals justify this daisy chain of buying?