February 8, 2002
How Citigroup Hedged Bets Against Enron
By DANIEL ALTMAN
t the time, 18 months ago, the idea seemed unthinkable: Enron (news/quote), the highflying energy company, in bankruptcy. But Citigroup (news/quote) wanted to hedge its bets.
The bank, a major lender to Enron, decided to protect itself in the unlikely event that its borrower faltered. Now it is looking smart while others are smarting.
To protect itself, Citigroup created securities that functioned like an insurance policy. If Enron stayed healthy, buyers of the securities would receive a steady return. But if Enron ran into trouble, Citigroup would stop paying the return, keep the investors' principal and instead give them Enron debt. Now those investors are left to fight for repayment in bankruptcy proceedings.
The securities, totaling $1.4 billion, were issued from August 2000 to May 2001. Citigroup refused this week to answer repeated questions about its choice of timing, except to say that it had intended to hedge its existing and potential future exposure to Enron. It acknowledged that the hedge was its largest against any company. When the final securities were sold, the issue was the largest of its kind ever.
The securities appear to cover Citigroup's potential losses from Enron, which in fact filed for bankruptcy protection in December. Citigroup has put its Enron loan exposure at $1.2 billion, though it also has some insurance-related obligations. Enron's pipelines serve as collateral for about half the loans, but the remainder is unsecured. The other big lender to Enron, J. P. Morgan Chase (news/quote), has put its exposure at more than $2.6 billion. J. P. Morgan Chase relied on surety bonds for some protection. Those bonds are now the subject of a legal dispute, but Citigroup's special securities appear to have provided substantial protection.
"In a sense they should be bragging about it," said Jose A. Lopez, a financial economist at the Federal Reserve Bank of San Francisco, "because they created some very useful financial instruments."
Craig Woker, a financial services analyst at Morningstar, the investment research company, said gloating would seem inappropriate after Enron's demise. But he wondered whether Citigroup had simply been extra cautious or had special information at the time.
"Citigroup and J. P. Morgan, as the two largest companies involved in Enron — somebody at those companies should have had enough knowledge of the business to detect something awry that the typical Joe on the Street might not have seen," Mr. Woker said.
The type of hedge used by Citigroup has become popular among financial institutions in the last decade to remove risk from their balance sheets. In the Enron case, though, Citigroup sold the securities at unusually favorable rates.
Citigroup set up paper companies, the first in August 2000 and three more in May 2001, that offered five- year notes. When the companies, incorporated as trusts, opened for business, they sold investors a type of credit derivative called credit-linked notes. Investors received a steady stream of fixed payments on the notes. Citigroup invested the investors' money in a combination of highly rated corporate and government securities.
If the notes' five-year terms elapsed without incident, Citigroup promised to return the investors' principal. But the contract stated that if Enron ever went bankrupt, Citigroup would take possession of the highly rated securities and give the investors unsecured Enron debt instead. The investors would then — and now have to — settle with Enron's other creditors in bankruptcy court.
The notes worked like an insurance policy: Citigroup paid a premium in the form of interest payments, and if Enron collapsed the bank would receive significant compensation in the form of high-quality securities.
Citigroup stated this week that it had set up the trusts to reduce its existing Enron-related risk and to provide a hedge against possible future exposures.
The bulk of the hedge was created in May 2001 and was then identified as a record issue of credit-linked notes: $855 million worth, in three currencies.
Perhaps by coincidence, the earlier issue, in August 2000, occurred as Enron's share price began to fall. By May 2001, when the bulk of the notes followed, Enron's stock had fallen to a level that threatened to force the company to issue additional stock to compensate certain trusts or partnerships for the loss in stock value.
Whatever the reason for Citigroup's move, the terms of the $855 million issue were unusually good for Citigroup and poor for investors. The memorandums describing the trusts clearly stated that "the notes are subject to the same credit risks" as Enron's regular bonds. Yet the interest rates offered to investors were lower than those paid on issues by other companies deemed just as safe as Enron.
When Citigroup organized the last issue last May, Enron had a credit rating of Baa1 from Moody's (news/quote). Moody's and Standard & Poor's assigned similar ratings to the credit- linked trusts. Yet the notes paid a rate similar to what was being paid by corporate bonds that Moody's viewed as much safer.
The notes paid 7.37 percent if denominated in dollars, and less if denominated in euros or British pounds. The rates were similar to the average interest then being paid by Aaa-rated bonds. The average for companies with Enron's rating, Baa, was 8.07 percent.
Thomas J. McCool, the General Accounting Office's managing director for financial markets and community investment, said this week that the rates seemed low for credit linked to a company whose rating never rose higher than Baa1.
"It's very strange, and the question I have is who was dealing with them, and who was willing to extend this credit for someone who's not a particularly high credit-rating institution," he said.
Credit-linked notes are typically the product of a negotiating process involving the sponsors of the trust and the potential investors. Citigroup stated that it was unaware whether Enron itself was among the notes' first buyers.
Allowing Citigroup to sell the notes at below-market rates might have benefited Enron, however, if it encouraged Citigroup to make more loans to the energy trader.