Did Citi Get a Sweet Deal? Bank Claims SEC Settlement on One CDO Clears It on All Others

by Jesse Eisinger and Jake Bernstein ProPublica

In the run-up to the global financial collapse, Citigroup2019s bankersworked feverishly to create complex securities. In just one year, 2007, Citimarketed more than $20 billion worth of deals backed by home mortgages toinvestors around the world, most of which failed spectacularly. Subsequentlawsuits and investigations turned up evidence that the bank knew that some of theproducts were low quality and, in some instances, had even bet they would fail.

Thebank says it has settled all of its potential liability to a key regulator2013 the Securities and Exchange Commission — with a $285 million paymentthat covers a single transaction, Class V Funding III. ProPublica first raisedquestions about the deal [1] in August 2010.  Inannouncing a case, the SEC said it had identified one low-level employee, BrianStoker, as responsible for the bank2019s misconduct.

Itmade no mention of the dozens of similar collateralized debt obligations, orCDOs, Citi sold to investors before the crash.

A bankspokesman said the SEC would not be examining any of those deals. 201CThis meansthat the SEC has completed its CDO investigation(s) of Citi,20192019 the spokesmanasserted 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.

DidCiti get a sweet deal? Some observers think so.

“Citibankarranged countless CDOs that were built to fail, but the SEC apparently limitedits case to a single CDO where they had particularly vivid and powerful proof,201Dsays Stephen Ascher, a securities litigator at Jenner & Block, which hassued Citibank on various structured finance transactions.

201CThisrepresents extreme caution, at best — and a failure to grapple with themagnitude and harmfulness of the misconduct, at worst.”

ProPublicahas been investigating the practices of the investment banks in the lead-up to thefinancial crisis for three years. Our research found a number of Citi CDOssimilar to the deal featured in the SEC2019s Class V complaint, and moreinformation on Citi2019s CDO business has emerged in lawsuits and subsequentinvestigations. Responsibility for these practices did not begin or end withMr. Stoker. Among the questions still unanswered: How much did Stoker2019s immediatebosses know? What did the heads of Citigroup2019s CDO business, fixed incomebusiness and trading businesses know about Citi2019s CDO dealings?

Inthe settlement announced this week, the SEC charged Citigroup with misleadingits clients in the $1 billion Class V Funding III. The regulator said that thebank failed to disclose that it, rather than a supposedly independentcollateral manager, had played a key role in choosing the assets in the dealwhen the bank marketed it to clients. Citigroup also failed to tell its clientsthat 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 SuisseAlternative Capital, which was supposed to choose the assets that went into theCDO, and a low-level executive at that firm, with securities law violations.

Stokerbecomes only the second investment banker after Goldman Sachs2019 Fabrice 201CFabulous Fab201D Tourre tobe charged by the SEC in conjunction with the business of creating CDOs, whichwere at the heart of the financial collapse in the fall of 2008. According tothe 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.

TheSEC complaint shows that Stoker was regularly communicating with other Citiexecutives about his actions. One top Citi executive coaches employees in anemail that Credit Suisse should tell potential buyers of Class V about how itdecided to purchase the assets, even though Citi, not Credit Suisse, was makingthe calls.

InOctober 2006, people from Citi2019s trading desk approached Stoker about shortingdeals that Citi arranged. Later, in Nov 3, 2006, Stoker2019s immediate bossinquired about Class V Funding III. Stoker told his boss that he hoped the dealwould go through. He wrote that the Citi trading group had taken a position inthe deal. Citi2019s trading desk was shorting Class V Funding III, betting thatits value would fall. Stoker noted that Citi shouldn2019t tell Credit Suisseofficials what was going on, and that Credit Suisse had agreed to be themanager of the CDO 201Ceven though they don2019t get to pick the assets.20192019 Less thantwo weeks later, this executive pressed Stoker to make sure that their group atCiti got 201Ccredit201D for the profits on the short.

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

If ClassV Funding III was some outlier, the SEC2019s action might make more sense. But itwasn2019t.  Citigroup2019s CDO operationchurned out at least 18 CDOs around the same period. Often they were largeCDOs, created with credit default swaps, effectively a bet that a given bondwill rise or fall. Most of the CDOs included recycled Citi assets that the bankcouldn2019t sell. By purchasing pieces of its older deals, Citigroup couldcomplete deals and keep the prices for CDO assets higher than they otherwisewould be. Some investors helped picked the assets and then bet against them,facts that Citi didn2019t clearly disclose to other investors in the deals.

Closingthe book on Citi2019s CDO business means the public may never know the true storyof Citigroup2019s, and Wall Street2019s, actions during the financial crisis. One ofthe 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 rootof the problems with securities Citi convinced it to insure. A shareholder classaction lawsuit that is wending its way through the courts has the potential to revealsome details, but often such cases are settled with evidence then sealed frompublic view.

Amongthe unresolved questions: What was Citigroup2019s role in a series of dealsinvolving Magnetar, an Illinois-based hedge fund thatinvested in small portions of CDOs and then made big bets against them?  Our investigation showed that Citi puttogether at least 5 Magnetar CDOs worth $6.5 billion [2].  Did Citi mislead the investors who lostbig on these deals?

Hereare some other questions about Citi CDOs created around the time of Class VFunding III:

  • 888Tactical Fund. A February 2007, $1 billion deal, ithad a significant portion of other Citi deals in it. Did the bank haveinfluence over the selection of the assets, as it did in Class V Funding III?
  • AdamsSquare Funding II. A $1 billion March 2007 deal. The pitch-book to clients forClass V Funding III was adapted almost wholesale from this deal, according tothe SEC complaint. Was Citigroup shorting this deal, or adding assets that wereselected by others to short the deal? And was that adequately disclosed toclients?
  • RidgewayCourt Funding II. Completed in June 2007, this $3 billion deal contained amysterious $750 million position in a CDO index. Experts believe that suchpositions were included for the purposes of shorting the market. Did Citidisclose why it included these assets to the investors in this CDO? As much as30 percent of the assets in the deal were from unsold Citi CDOs. Was this adumping 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 likeRidgeway II. It had a large portion of other CDOs, much of which came fromother Citi deals, including $260 million from Adams Square Funding II. Did Citiadequately disclose to investors what they were buying?
  • ClassV Funding IV. A $2 billion June 2007 deal, Citi appears to have done thisdirectly with Ambac. The SEC complaint about Class VFunding III makes it clear that Ambac was unaware ofCiti2019s position in that deal. Did the bank disclose more to Ambacin this deal?
  • Octonion. This $1 billionMarch 2007 CDO bought some of Adams Square Funding II. Adams Square II bought apiece 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 collateralmanagers involved in these deals justify this daisy chain of buying?