Cassandra Among the Banksters

The banksters, as some people have taken to calling them, have had a mixed run lately.¹ Just a year or two ago, at the height of the financial crisis and during its immediate aftermath, most Americans were acutely aware of the damage done to our financial system and our economy by lax lending standards at many of our major financial institutions and their parallel willingness to take what amounted to one-sided gambles with other people’s money. There was as well the personal cost inflicted on millions of families, as borrowers went bankrupt or owed more on their mortgages than their homes were then worth.

Congress, with the encouragement of President Obama, was writing new legislation to restrain the most dangerous excesses and limit the damage should another such system-wide disaster threaten in the future. The huge sums paid out to top-level executives, often regardless of whether their institutions prospered—in some cases, even whether they survived—only intensified the opprobrium. In short, bankers were in bad odor.

Memories are short. Today many of the country’s largest financial institutions are eagerly engaging again in the kinds of risk-taking activities that put them in trouble just a few years ago, among them the use of highly risky loans and derivatives. With a very few isolated exceptions, the worst individual offenders have escaped prosecution. Most executives have retained all, or at least the greater part, of the outsized compensation they received for leading their institutions to ruin. (Angelo Mozilo, former CEO of Countrywide Financial, the nation’s largest mortgage lender, faced civil fraud charges for misleading investors about the risks involved in subprime lending; the charges stuck, and so he was allowed to keep “only” $454 million of the $521.5 million that he made between 2000 and 2008.)

The economy’s turnaround, together with continuing near-zero interest rates for most kinds of deposits, has boosted the profits of lenders who can take advantage of such cheap money. The resulting (very partial) recovery in the stock prices of banks that would have failed in the crisis except for government assistance has become an occasion for a new round of large salaries and bonuses. Shareowners in Bank of America, for example, saw their stock fall from $55 per share to $2.50; with the recent increase to $13, the firm set CEO Brian Moynihan’s 2010 pay package at $10 million.

More important for the future, the country’s largest financial institutions and their leaders have regained sufficient confidence that they are again seeking to resist or undermine restrictions on their activities. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which Congress passed last July, imposed several significant changes (some for the better, some not) on how US financial firms do business and how they are regulated. But the new legislation failed to specify how to implement many of its key reforms, such as changes in financial institutions’ capital structures. Instead, the bill left the actual decisions to one or another regulatory agency: the Federal Reserve Board, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and more besides. The sheer volume of work to be done under the bill—some 350 separate rule-making efforts, in principle all to be completed within a year of the bill’s passage—is now overwhelming the capacity of the government’s regulatory apparatus.² Predictably, delegating these decisions to individual agencies has been an invitation to bankers and other potentially affected parties to lobby for lenient treatment, hoping to win back at the regulatory level the battles they appeared to lose in the legislation.

Citibank, currently the country’s third-largest bank, and linked through its holding company Citigroup to other major financial institutions like Salomon Brothers and stockbroker Smith Barney, is a particularly interesting case. Citi was especially active in securitizing residential mortgages—that is, acquiring the loans, assembling them into packages, and selling securities backed by them, all in exchange for considerable fees. But along the way the bank also kept some of the securities it had created, thereby exposing itself to the same losses that hit its investors. The process continued well after house prices started declining in the summer of 2006, while concerns about the creditworthiness of recently issued mortgages mounted. As the bank’s CEO Charles Prince famously said a year later, “As long as the music is playing, you’ve got to get up and dance.”

In fact the music had already stopped. By mid-2008 Citi had taken losses of $55 billion, mostly on its portfolio of mortgage-backed securities including collateralized debt obligations (a form of derivative based on underlying bonds backed by subprime and other mortgages).³ The bank was actually holding most of these assets through separately structured entities from which in principle it could simply have walked away, just as Bear Stearns did when that firm let one of its sponsored hedge funds collapse in the summer of 2007. But Citi had apparently marketed claims against these special-purpose vehicles as if it stood behind them. The bank did not want to suffer the damage to its reputation from letting the investors take the losses. If its large depositors had taken out their money in the same way that Bear Stearns’s short-term creditors had, Citi would have been ruined just as Bear Stearns was.

The bank therefore took the assets back from investors and absorbed the losses itself. Without the $45 billion in direct capital infusions it received under the Treasury’s TARP and TIP programs, a guarantee from the Treasury and the FDIC of more than $300 billion of the bank’s troubled assets, and the further FDIC guarantee of new debt issued by all banks, Citi would presumably have failed. Even with that assistance, by early 2009 Citigroup stock had fallen from $55 per share, as recently as late 2006, to just 97 cents.

Despite the destruction of so much of the stockholders’ value, and notwithstanding the enormous taxpayer assistance, Citi’s management announced in the spring of 2009 that it was paying out $5.3 billion in bonuses for 2008, including payments of more than $5 million apiece to forty-four employees of the bank.⁴ Because of the $45 billion investment of TARP and TIP money, by 2009 the US government was Citigroup’s largest shareowner.⁵ Hence the issue these lavish bonuses raised was not merely a private firm’s right to set its employees’ compensation. What Citi’s management was giving away was, in significant part, the taxpayers’ money. Yet the Obama administration voiced no objection, at least not publicly. As a political matter, this was when President Obama took responsibility for the bankers’ excesses.

The immediate consequence, of course, was that the bonuses were paid. Of greater significance is the current US political dynamic, otherwise difficult to comprehend, in which populist resentment at the banksters’ excesses is today directed at Obama and not at the Republicans who are resisting measures to restrict banks’ risk-taking and are also seeking to strip the power of the new Consumer Finance Protection Bureau created by Dodd-Frank.

Nor was the financial crisis of 2007 to 2009 the first time Citibank had gotten into trouble. In the early 1990s the bank was probably insolvent after its real estate and leveraged buyout portfolios suffered major losses. In the early 1980s the bank was in a similar situation after many of its loans to Latin American and other developing-country borrowers turned sour. (Presaging Charles Prince a quarter-century later, the CEO at the time, Walter Wriston, famously justified these loans on the ground that “countries don’t go broke.”) Neither of these episodes required a government infusion of capital. Instead the bank survived through a combination of accounting strategies that enabled it to avoid recognizing the loss of value on its troubled loans, implicit permission from the regulators to operate while undercapitalized, and other forms of regulatory forbearance.

A disinterested observer might well wonder, wasn’t there anyone at the bank who learned from these earlier near failures? It turns out there was. William Rhodes, Citi’s international banker who had led the complex negotiations that resolved many of these earlier difficulties, publicly warned as early as the summer of 2005 that “lenders and investors have to be careful that they exercise proper risk management. If they don’t they’re going to get burned.”⁶ By the spring of 2007—more than three months before his boss Charles Prince insisted that the bank had no choice but to keep dancing—Rhodes was calling attention to “pockets of excess” in the financial system that were becoming “harder to ignore,” pointing in particular to the US housing and mortgage markets as “one such example of excess.” Writing in the Financial Times, he predicted trouble to follow:

As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface…. I believe that over the next 12 months a market correction will occur and this time it will be a real correction.

The solution? It was, he wrote, clearly “the time to exercise greater prudence in lending and in investing and to resist any temptation to relax standards.”⁷ But of course by then it was already too late. Rhodes, mainly concerned with international finance and in any case not the bank’s CEO, could issue warnings; but he was not in charge.

Now Rhodes has written Banker to the World, a book recounting his experiences and highlighting the lessons he’s drawn from his fifty-three-year career at Citi. Rhodes’s recollections are lively and richly detailed, replete with glimpses of top-ranking personalities from the world of banking and government interacting under pressure, and they provide a rare window into how these important but normally secretive operations of high-level international finance actually work. As the title suggests, the principal focus is his role as not only Citibank’s chief international representative and negotiator in international debt restructurings but, more often than not, the chairman of the committees that represented all of the lenders in episodes like the Latin American debt crisis of the early 1980s and the Asian debt crisis of the late 1990s. As one would also expect for someone working at such a senior level at so important a financial institution, Rhodes was in close touch with the International Monetary Fund, the governments of the countries abroad with which he worked, and parts of the US government like the Treasury and the Federal Reserve System, all at the very top levels.

Banker to the World consists mostly of first-person accounts of Rhodes’s involvement in these and other activities over the years, organized not chronologically but in groupings intended to illustrate various “lessons.” The arrangement is useful for some purposes, less so for others, and the assignment of particular episodes and recollections of Rhodes’s actions to illustrate one “lesson” rather than another is often somewhat arbitrary. He gives a fascinating account of his role in “restructuring” Mexico’s foreign debt in 1982–1983, for example (“restructuring” mostly being a euphemism for changing the terms of a loan so as to reduce the obligations of the debtor without requiring the lenders to record losses on their books). He describes how he had to deal directly with not only the Mexicans and 526 separate lending banks but also Federal Reserve Chairman Paul Volcker and IMF head Jacques de Larosière before there was a clear consensus to rescue Mexico from possible default. But why this episode illustrates the need to “Take Prompt, Comprehensive Action,” rather than, say, to “Execute in a Timely Fashion” or “Build Consensus and Use Innovative Ways to Solve Problems” is not evident.

The real value of these first-person accounts lies not in the how-to lessons, but in the insight they provide into the ways international debt negotiations take place, including both questions of policy and the personal involvement of individual bankers and bureaucrats. A consistent theme throughout is the effort, often highly successful, to align the objectives of public and private sectors. Clearly it wasn’t in the interest of developing countries that had overborrowed to default on their obligations and therefore suffer exclusion or hard terms on future borrowing; nor was their defaulting in the interest of the banks that had lent them the money, or that of the governments of the banks’ home countries.

The art that Rhodes practiced for so many years was to find conceptual approaches and then detailed operational strategies for avoiding outcomes nobody wanted, as he did in Mexico in 1982 and again in 1990, Brazil in 1983, Argentina in 1992, Turkey in 1994 and again in 2002, Korea in 1997, and Uruguay in 2002. In each case Rhodes had a central part in resolving debt crises caused by underlying problems such as overborrowing, declining currencies, volatile capital flows, or poorly run banking systems.

The solution in each case turned on getting the disparate parties to see how, and where, their interests overlapped. Not surprisingly, in describing his various activities outside the realm of Citibank business and lending—lobbying for the still-pending US–Korea free trade agreement, for example—Rhodes often portrays himself as acting in large part in the public interest. As indeed he is. But what’s good for American business, or for foreign governments and companies that do business with America, is also profitable business for American lenders like Citi. In Banker to the World, the presumption isn’t hidden; it’s plain throughout.

As Rhodes’s telling of these stories also makes clear, both international debt negotiations and other aspects of either banking or policymaking are intensely personal undertakings. A second continual theme in Rhodes’s book is that relationships matter—hence his insistence on face-to-face dealings, or at the very least direct conversation by telephone. His advice for the era of e-mail and faxes: “Just get on a plane or pick up the phone and get to the heart of the matter.” And even in settings in which direct conversation is part of the program, in his mind it’s the off-line asides that matter:

The odd thing about debt negotiations is that very little actually gets decided in the room itself. Much is worked out in the corridors and hallways, and by phone between the parties. Preagreements in corridors are the norm, and then everyone comes back into the room to give a verdict on the particular term sheet that is on the table at the time.

Taking the personal approach can sometimes be rough. Of his role in chairing the committee that worked out Argentina’s debt problem in 1992, Rhodes writes:

When it came time to push for a final agreement…I insisted that everyone involved remain at the negotiating table all night long, for two nights in a row…. People were exhausted, ready to drop…. I insisted that they stay. People were napping amidst pizza boxes on chairs in the hallways, and drinking cup after cup of coffee.

By Sunday night, you got the feeling that the participants would have said yes to almost anything just to be able to go to bed. That, I knew, was when we could make the most progress.

The obvious question Rhodes doesn’t address in this book is why he was so much less successful in getting his own bank to protect itself against the dangers that he clearly saw coming in the most recent financial crisis. He recalls that after having to write off what he refers to as “a then shocking $1.4 billion” in real estate loans in 1992, Citibank, under CEO John Reed, put in place a new, comprehensive risk management system and was therefore on guard against what happened in the Asian debt crisis later in the decade. By the mid-1990s, he reports, “Throttling down the engine in the middle of a race seemed nuts from the perspective of those on the ground. But in New York, we knew that a crash was coming.” Why, then, did the bank’s risk management fail so badly a decade later that Citi lost forty times $1.4 billion? One possible explanation would point to the changes in CEOs: from Reed to Sanford Weill, and then to Charles Prince. But Rhodes simply doesn’t say.

In the opening pages of Banker to the World, Rhodes highlights some of his prescient warnings from the mid-2000s. But then, although the parallels between the 2007 financial crisis and many of the earlier debt crises on which he worked are plain enough, he never comes back to the latest experience. Why couldn’t he corral Mr. Prince for two successive nights in a hotel conference room, with nothing to go on but pizza and coffee, until he agreed to run the bank more responsibly? Surely Citigroup’s shareowners, not to mention the rest of America’s citizens, would have been grateful. Maybe a corporation’s senior vice-chairman just doesn’t talk to its chairman that way. But if not, that would be an important point about corporate management well worth making.

The parallel and deeper question that Rhodes doesn’t address in Banker to the World is whether the underlying presumption that banks and countries simply must not default is valid. Rhodes is explicit that the goal in most of the many negotiations he led was to prevent lapses in paying back debts that would then have locked the borrowers out of the credit markets, or at least subjected them to harsh terms on future borrowing. Such defaults would also have imposed losses on the banks. They might have been costly as well for the economies of both the borrowers and the lenders.

But looking back over the fifty years of Rhodes’s remarkable career at Citi, is it obvious that the discontinuities those defaults would have entailed would have been harmful in the long run? Maybe large-scale borrowers who get to “restructure” their debts, with little inconvenience inflicted on anyone except the finance ministers forced to nap amid the pizza boxes, become less inclined to restructure their financial systems or their economies, along with the policies that caused them to borrow foolishly in the first place. Maybe the banks that escape the consequences of their poor lending policies are less likely to rethink how they manage the risks inherent in their business.

It also seems plausible that banks that manage to survive near failures are more prone to further reckless behavior in the future because of the stockholder dilution that occurs when, in order to address the problems created by taking losses, the bank has to raise capital. Most of Citigroup’s 29 billion shares outstanding today (including those received by the US government, which the Treasury has now sold) were issued since the crisis. If we also take into account the many thousands of pre-2007 shareowners who have by now sold their stocks—and who may futilely contend that they were victims of mismanagement but can no longer even withhold their proxies—only a minority of the firm’s shareowner base today consists of investors unhappy at management because of their loss of value on their holdings.

The recent US experience presents a further interesting contrast of this kind. The great majority of the homeowners who saw the value of their houses decline to less than they owed on their mortgages have been left to live with their losses, or to default, and thereby risk foreclosure and eviction. To be sure, some of these people bought with no money down, or lied about their income or assets, and should not have obtained mortgages in the first place. But millions of families who did neither have been severely affected as well, some to the point of desperation. By contrast, with the signal exception of Lehman Brothers, no significant bank or other financial firm has been allowed to fail.

It seems clear that when American families buy houses in the future, or borrow for other purposes, many will take a more cautious attitude. Whether America’s bankers will run their firms more responsibly in the future remains an open question. They would do well to have people like William Rhodes in their senior management—and, next time around, to listen to them.