Every once in a while I almost write "I don't envy big bank CEOs," and then I consider my own finances and the mood passes. But it does seem hard, no? The job is basically that you run around all day looking at horrible messes – even in good times, there are some horrible messes somewhere, and what is a CEO for if not to look at them and make decisive noises? – and then you get on earnings calls, or go on CNBC, or sign 10Ks under penalty of perjury, and say "everything is great." I mean: you can say that some things aren't great, if it's really obvious that they're not. If you lost money, GAAPwise, go ahead and say that; everyone already knows. But for the most part, you are in the business of inspiring enough confidence in people that they continue to fund you, and if you don't persuade them that, on a forward-looking basis, things will be pretty good, then they won't be.
Also, when you're not in the business of convincing people to fund you, you're in the business of convincing people to buy what you're selling and sell what you're buying, which further constrains you from saying "what we're selling is dogshit."1
Anyway I found a certain poignancy in Citi's correspondence with the SEC over Morgan Stanley Smith Barney, which was released on Friday. Citi and Morgan Stanley had a joint venture in MSSB, and MS valued it at around $9bn, and Citi valued it at around $22bn, and at most one of them was right and, while the answer turned out to be "neither," it was much closer to MS than C. Citi was quite wrong, and since this was eventually resolved by a willing seller (Citi) selling to a willing buyer (MS) at a valuation of $13.5bn, Citi had to admit its wrongness in the form of a $4.7 billion write-down, and the stock did this:
Which is the market's way of saying: no biggie Vikram, we already knew you'd be taking the writedown, honestly we thought it'd be worse than that, we just didn't say anything because we didn't want you to feel bad, but we're glad that's cleared up now.
But the SEC doesn't get to do that, because – and this is sort of endearing – the SEC has to pretend that a company's financial statements convey meaningful information about the actual world, and so last year they sent Citi a bunch of letters to the effect of "um, really, with that MSSB valuation?" To be fair even Citi was admitting, back in its 10-K a year ago, that MSSB wasn't worth what its balance sheet said it was worth – but it said that this was a temporary impairment and so didn't need to be reflected on Citi's financials since MSSB would recover soon and anyway it's not as if Citi was looking to sell at a depressed price. Here is how the SEC responded in April:
We note your disclosure related to the temporary impairment of your equity method investment in the Morgan Stanley Smith Barney (MSSB) joint venture. Please address the following:
- You assert that, as of December 31, 2011, you do not plan to sell your investment in this joint venture prior to recovery of the value. Please tell us how you were able to reach this conclusion given the fact that you are currently in negotiations with Morgan Stanley to sell at least part of your equity interest in this joint venture pursuant to options held by Morgan Stanley.
- We note that you have based the fair value of this equity investment on “the midpoint of the current range of estimated values.” However, you do not disclose this range, nor do you disclose how the range was estimated.
Citi's response is absolutely gorgeous; it says:
- We are not in fact negotiating with Morgan Stanley about selling the rest of MSSB, and
- We can't disclose our internal estimate of MSSB's value, because that would hurt us in our negotiations with Morgan Stanley about selling the rest of MSSB.
See what they did there?2 The SEC did, a few months later anyway, when the negotiations got so advanced that the SEC pushed Citi for more information about its internal valuation of the MSSB joint venture. Citi obligingly provided that valuation to the SEC, confidentially, ten days after it disclosed the write-down.
Also during these negotiations Citi's investment banking division provided a valuation of MSSB "that slightly exceeded Citi's carrying value of approximately $11 billion for that 49% interest as of June 30, 2012." So:
- Citi provided a valuation of an asset to its counterparty as a negotiation tool,3
- which was higher than the valuation it reflected in its publicly filed financial statements,
- which was higher than its internal estimate of the correct valuation,
- which was closest to the market's estimate of the correct valuation, and the ultimate valuation at which Citi sold the asset.
So Citi "knew" that its financials, and the valuation it gave in negotiations with MS, were "wrong." Making this all a little sketchy, but also a lot no-harm-no-foul. Citi was locked into putting a brave face on its MSSB valuation, because admitting that there was a problem would have actually cost shareholders money, in the form of a worse negotiating position with MS. And so Citi provided two separate estimates of MSSB's value, to MS and to Citi's own shareholders, that did not accurately reflect what it thought it would ultimately get for MSSB. And then it didn't. And since everyone pretty much knew that that was going on, no one has much cause to complain. The typical fraud lawsuit starts with "you lied about X, and when you came clean, the stock dropped by $Y, so give us $Y"; here the lawyers' damages would be negative. Citi came clean, as it were, about MSSB, and the market breathed a sigh of relief.
So, I imagine, did Vikram Pandit, though in his case the relief didn't last long. Citi did what probably really was the right thing for shareholders: it maintained with a straight face that MSSB would be cheap at $22 billion. That was wrong, of course, but since no one believed it, it all worked out okay.
Citi: SEC letters and responses [EDGAR]
SEC Pressed Citi for More Details on Brokerage Joint Venture [WSJ]
1. Unless you're Lloyd Blankfein? This is a fine line.
2. No really, it really says this. To be fair the second part is phrased as "such disclosure could place Citi at a competitive disadvantage in the event that negotiations with Morgan Stanley regarding fair value were to take place in connection with the exercise of the above-referenced options."
3. Ooooh is that bad? Is it Fraud to tell someone that an asset you own is worth $100X when you value it internally at $80X? No, right? I mean not if your counterparty is Morgan Stanley. Ponder CDO cases however.
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