Former Citi Execs Did Not See Wave of Subprime Fallout Coming

The second day of hearings by the Financial Crisis Inquiry Commission (FCIC) began with a sober apology from an ex-executive at one of the largest participants in subprime lending and securitization. “Let me start by saying I’m sorry,” said Chuck Prince, former chairman of the board and CEO of Citigroup (C) from October 2003 through his resignation in November 2007. “I’m sorry that the financial crisis had such a devastating impact on our country. I’m sorry for the millions of people, average Americans, who have lost their homes. And I’m sorry that our management team, starting with me, like so many others could not see the unprecedented market collapse that lay before us.” The apology followed expert testimony yesterday that competition within the subprime mortgage market led to a spreading of risk and a fragmentation of responsibility for faulty loans and financial products. He said the market for subprime mortgage originations and securitization was fueled by low interest rates, government policies encouraging homeownership, a patchwork of lending regulation and investor demand for high-yield structured finance products. The global proliferation of securitized subprime mortgages acted as the “immediate trigger” to the current crisis, according to earlier testimony of former chairman of the Federal Reserve board of governors, Alan Greenspan, before the FCIC yesterday. Citi ultimately lost $30bn on highly-rated, super senior collateralized debt obligations (CDOs), which were derived from securities backed by subprime mortgages. “[T]he largest losses at Citi emanated from what were perceived at the time to be extremely safe ‘super-senior’ tranches of CDOs that carried the lowest possible risk of default,” Prince said in a prepared statement (download here). “It bears emphasis that Citi was by no means alone in this view and that everyone, including our risk managers, government regulators, other banks and CDO structures, all believed that these securities held virtually no risk — a perception strongly reinforced by the above-triple-A rating bestowed by the rating agencies.” Robert Rubin, former chairman of the executive committee of the board of directors at Citi, said the bank’s losses were comparable to other financial institutions, outside of significant losses in CDOs. “[T]hese losses occurred in the context of a massive decline in the home real estate market that almost no financial models contemplated, including the ratings agencies’ or Citi’s,” Rubin said in prepared remarks (download here). FCIC members noted Prince and Rubin claim they were not aware of Citi’s exposures to CDOs until September 2007. FCIC vice chair Bill Thomas expressed some disbelief the bank was unaware of the significant risk posed by CDOs. He called out the ex-execs for blaming the poor quality of the CDOs on Citi’s books to lax regulation of loan origination that allowed for the influx of subprime loans that ended up in structured products. Thomas likened the blame-shifting to a shoe manufacturer blaming the leather supplier for the poor quality shoes it manufactures. “You didn’t have to do it,” Thomas told them, referring to the securitization of subprime mortgages. Rubin noted there is no easy way for a board of directors to track the exposure to CDOs and underlying risk in an institution the size of Citi. “You’re talking about a level of granularity” a board would not have, he told the FCIC. He recommended a focus on regulation to complement actions on the part of the private banking industry. Rubin said financial reform should include “substantially increased leverage constraints,” derivatives regulation, resolution authority “to avoid the moral hazard of ‘too big to fail,'” as well as consumer protection. Write to Diana Golobay. Disclosure: the author holds no relevant investment positions.

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