Blame Citigroup’s woes on the Citi-Travelers Merger

Justin Fox — rightly, I think — reckons that the repeal of Glass-Steagal was on net a good thing, not a bad thing, for the US banking system, if only because it has allowed big commercial banks like Bank of America and JP Morgan to buy failing investment banks like Merrill Lynch and Bear Stearns.

But what of Citigroup, the creature which caused Glass-Steagal’s repeal in the first place? Can we pin its problems, at least, on that decision, or would the same problems have cropped up at Travelers regardless? Justin writes:

The biggest problems at Citigroup have come from the Travelers’ side of the marriage. The Travelers insurance businesses have been spun and sold off, and Smith Barney, as part of Citi’s wealth management division, doesn’t seem to have been a disaster. But Citifinancial was a leading subprime mortgage lender, and Citi’s investment banking arm–the descendant of Salomon Brothers–got into mortgage securitization late and ended up with a huge pile of unsellable junk on its hands.

Now that junk has rendered all of Citi suspect.

First, Citifinancial is the rebranded Associates, which was bought by Citigroup in 1999, after the Travelers-Citicorp merger. Associates was a subprime lender which was considered a complement to Citibank’s higher-quality lending operations. I doubt that Travelers would have bought Associates on its own, and so it seems a bit of a stretch to say that Citifinancial came from the Travelers side of things.

But more to the point, Citi’s investment-banking arm would never have got into the mortgage business to anything like the degree it did were it not for the fact that it had recourse to Citibank’s enormous balance sheet. It’s the same as the story of how a small group in London called AIG Financial Products managed to blow up so spectacularly: it had recourse to AIG’s even-more-enormous resources.

Investment banks have a natural tendency to expand until they use all of the balance sheet they’re given. That’s one of the reasons the SEC’s 2004 decision to remove constraints on leverage was such a bad one — they’re constitutionally incapable of constraining themselves. And when they merge with — even when they’re taken over by — commercial banks, they invariably end up taking over the host organism and seeding their high-tech products all over its balance sheet.

The two most important people at Citigroup — Vikram Pandit and Robert Rubin– are both investment bankers. And it was the Citi-Travelers merger which turned the relatively sober Citicorp into an investment bank. So while I still think that repealing Glass-Steagal might have been sensible, the problem is that it was never accompanied by the extra regulation that these new merged entities required. Quite the opposite, in fact. And so, with no idea how to run such a thing, Citigroup’s managers let it get to a point at which they could blow up spectacularly.