Citi Phibro Selloff Shows Government Sham

October 13, 2009

by Chidem Kurdas

You’d think that the federal government wants Citigroup to return to financial health—if for no other reason to recoup the $45 billion of taxpayer money spent to shore up the bank in the credit freeze. You’d think the government wants a real effort to boost efficiency and profits. You’d be wrong.

What the Feds chose is a political charade. The pay czar objects to the $100 million compensation due to Citi’s star energy trader. Since the trader is contractually entitled to a share of the profits from Phibro, the phenomenally profitable energy trading subsidiary, there is no legal way not to pay him. So instead Citi is pressured to sell Phibro.

The bank complies. Occidental Petroleum snaps up the business at a bargain basement price. The WSJ quotes Occidental’s president as saying, “If you’ve got to sell, why should I pay a premium? What leverage does the seller have?” The lucky buyer added that Citi would never sell Phibro if it weren’t for pressure by the government.

Citi’s balance sheet is now in worse shape. It lost one of the few businesses that made money last year and had to sell under the worst possible circumstances, created by the government. Instead of slimming down by gradually getting rid of inefficient divisions so as to become a better-run company, the bank was forced to almost give away a valuable asset. And this to make it look like the government combated excessive pay.

The traders’ compensation has merely been deferred. They’re going to receive the same amounts after Phibro becomes part of Occidental. Presumably, that does not look bad because Occidental is not a bank, did not receive government investment and is not under media  spotlight.

What’s been achieved is public relations flummery. In the name of the poor masses, the Obama administration battles filthy rich financial geeks, who are in any case suspect because most people can’t understand what they do. But it’s all a pretense. The traders will be just as rich, while the masses’ investment in Citi loses value.

But who cares about that? Officials have made the politically correct gesture.  Left to itself, Citi has a fair chance; overseen by Washington czars, much less so. This sorry episode demonstrates that as clear as can be.

Winston Churchill quipped that democracy is the worst form of government, except all the others that have been tried. A complementary motto would be that private enterprise is the worst type of economic player, except all government agents.

14 Responses to “Citi Phibro Selloff Shows Government Sham”

  1. Jim Says:

    The prism here is systemic organizational behavior; organizational hierarchies of any kind quickly rearrange themselves on something other than the profit motive. Politics then becomes the game.

    For profit organizations, it is the central role of boards to minimize the political effects of top management. Boards of Directors (partly because of their naive members) have done a terrible job of this in the last generation. The government does worse.


  2. I must disagree. Left to itself, Citi likely had no chance of surviving. The problem was not the compensation for the trader, but how it was being earned. It is not possible to consistently earn above-market rates of return (generating high compensation for traders) without taking on high risk. Insured despository institutions — especially those being propped up at taxpayer expense — cannot be permitted to engage in high-risk activities. The Administration got this one right.

  3. chidemkurdas Says:

    A small number of people do earn above-market returns decade after decade. The hedge fund industry would not exist if that weren’t the case. However, that’s not the main issue here. You may be right that risky trading should not be allowed to endanger an insured banking business. In that case, Citi should sell all the trading operations it owns, not just one that happens to be extremely profitable. More importantly, it should sell them gradually, not in an emergency fire sale that is politically expedient. Why cause the bank’s asset to sell at an artificially low price? How did that benefit taxpayers, who own one-third of the company?


  4. I said one cannot consistently earn higher returns without taking on additional risk. And, yes, I do not think that insured banks should not be permitted to operate hedge funds (which are different from trading for a customer’s account). Citi has been in fact under pressure by the regulators to downsize and reduce risk. Management apparently played a game of chicken with regulators and lost at its stockholders’ expense.

  5. chidemkurdas Says:

    I’d have thought regulators have a responsibility not to make the bank’s situation worse–seeing as some 34% of the stock is owned by taxpayers. But obviously the political agenda trumps all. By the way, this point I made in yesterday’s post is also made in the WSJ today:
    http://blogs.wsj.com/capitaljournal/2009/10/14/when-profit-triggers-political-peril-americans-lose/


  6. Um, I might be mistaken in this analysis, but isn’t Treasury largely captured by Goldman-Sachs? And isn’t Citi a competitor to GS?

    I think O’Driscoll is right about Citi being a basketcase, but regardless, why would the feds have a strong interest in recouping taxpayers’ dollars?

    As for consistently earning above market returns in finance, how much of this is fraud?

    Here’s something that, if true, puts these “earnings” in a rather different light:

    “Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade. That means that the capital markets decapitalize the real economy. Too often, they do so in order to enrich corrupt corporate insiders through accounting fraud or backdated stock options.”

    Source: http://www.newdeal20.org/?p=5330


  7. Interesting point on Goldman Sachs and worth thinking about. On not making the bank’s situation worse: there is moral hazard at work. The Treasury is trying to offset the bad effects of one policy (which encourages excessive risk-taking) by forcing banks to curtail risk. One cannot apply a free-market model to a corporatist financial system. To return to Mr. Steele’s point, if we have learned one thing from the crisis it is that a large percentage of profits in financial services are illusory.

  8. Peter Canning Says:

    “I said one cannot consistently earn higher returns without taking on additional risk.”

    This is flawed economic analysis. You presume skill does not exist. Further, even without skill one can observe that in the equity market, risk (as measured by standard deviation) is quite unrelated over long periods. Academic studies of this exist, as well as simple charts put together by practitioners (risk and return of Russell Style Indecies). The naive Efficient Market Hypothesis has no place in real world analysis in any of its forms.

    The market for energy is likely less efficient than that of the equity market. A simple example of this is the massive amounts of “dumb money” piling into long only front month futures etfs. Most of those buying theses funds to gain exposure to “commodity returns” had little to no knowledge of the effects of contango and the cost of rolling contracts. While Hall may have been taking large risks, you and I have no idea what sort of strategies he was employing, what remains is that Phibro was sold for significantly below market value. A business able to generate 100 million dollars to bonus the man running it was clearly worth far more than what OXY and other partners paid.

    As to the illusion of profit. Clearly fully liquid investments in exchange traded futures are hardly an illusion. This business is fully market to market and can go to cash.

    So, regardless of your thoughts on what banks ought be allowed to do (putting small percentages of capital in high return, low correlation trading strategies seems like a good idea to me), what the government did here was profoundly foolish. Color me shocked.


  9. There was nothing naive about what I said. The essence of economics is that there is no free lunch. And, at the risk of repeating myself once again, I said one cannot CONSISTENTLY earn higher profits w/o taking on commensurate risk. If the individual in question is doing this with some unique skill, then he will earn all the rents himself. Whoever employs him will earn only a normal (risk-adjusted) rate of return. That conclusion relies on standard competitive analysis. In that case, Citi was not necessarily silly to sell the company at book value. Citi was dependent for a substantial portion of its profits on this hedge-fund like operation. That in and of itself raises safety-and-soundness concerns. The regulators were belatedly doing their job. The housing bust testifies to the illusory nature of the profits previously reported by banks.

  10. Peter Canning Says:

    “The essence of economics is that there is no free lunch. And, at the risk of repeating myself once again, I said one cannot CONSISTENTLY earn higher profits w/o taking on commensurate risk.”

    This assumes zero entrepreneurial profit and perfectly efficient manager selection. It assumes an economy at equilibrium. These are incorrect assumptions. While it is easy to simply assume that the only way to do well in business is to take more risk, common sense (among other things) tells us this isn’t true. If Phibro offered Citi no risk adjusted returns, why would they give them a nickel? Why would anyone? Market efficiency that you claim exists, would not allow Hall to be in business. Further, as any student of portfolio management knows, gaining exposure to a wider variety of low correlated risks actually improves risk adjusted returns. Andrew Hall risk is no longer a factor that Citi has access to. That seems to be negative. Ultimately, the only reason that it would make sense to dump Hall for pennies on the dollar is that the risk that the government may ban energy trading by non-“hedgers”.

    Those with consistent skill will consistently produce consistently superior risk adjusted returns for both themselves, and their clients. This is observed empirically, and makes perfect sense logically. Skill is real, and it does take skill to recognize skill. Thus, superior risk adjusted returns are possible in the real world. This is in no way a free lunch.


  11. This discussion is rapidly becoming unproductive. I know what skill is and that it earns rent (and need not be shared). I know what moral hazard is and it needs to be constrained. Beyond that, the discussion is over.

  12. Matt Sikora Says:

    Doesnt it seem like there are far too many shady things going on with the government and the markets? Scams left and right. I understand they are “trying to help” but I dont even know anymore.

  13. gcallah Says:

    Where is that screen where I can unsubscribe to comments?


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