As home prices crested in 2006, investors found themselves too far from borrowers to judge the securities’ risk and rushed for the exits. Banks had trouble unloading their inventory. The busiest arrangers—Citigroup, Merrill Lynch, and UBS, among them—suffered billions of dollars in losses as the debt plunged in value. By the time of trading chief Forese’s November 2007 memo, it wasn’t clear there’d be much left but rubble for Tsesarsky to manage. In December analysts at Barclays predicted the safest portions of the securities could lose as much as 80 percent of their value. Many considered the instrument broken, and much of Wall Street left the market for dead.
Citigroup, however, wasn’t ready to give up. Executives, including Forese, viewed their experience in the business as the key to growth. Add to that Tsesarsky’s more than two decades in the mortgage markets, and Citigroup’s leadership thought it could make money and avoid another near-death experience, according to an executive privy to the discussions. In short, the bank decided to go long.
Ten months later, Lehman Brothers declared bankruptcy, plunging the world into a crisis that threatened the financial system. Citigroup needed a government transfusion of more than $500 billion, including emergency loans and asset guarantees— at least $14 billion for risky mortgages in Tsesarsky’s portfolio—and the U.S. Department of the Treasury took a 27 percent stake in the bank.
Even so, Tsesarsky’s team enjoyed more freedom than others, says a former colleague. In at least one instance, Tsesarsky helped persuade management to give more resources to the business, beating Bank of America and other rivals that didn’t want to commit the additional capital.
“It’s impossible to imagine. You’re being bailed out with one hand, and you’re pouring money into the very same assets that precipitated the bailout with the other.”
Citigroup was ready when the Federal Reserve Bank of New York auctioned a portfolio of CDOs in 2012. The team canvassed customers and collected orders, making pitch after pitch about its deep knowledge of the securities and their cheap prices, according to a person with knowledge of the strategy. In cases where the bank saw something too good to pass up but couldn’t persuade investors to bid, it used its own money to buy the debt, the person says. Of the more than $45 billion sold by the central bank, Citigroup won $6.3 billion, paying an average of 38¢ on the dollar.
Over the next few years, the bank reaped the rewards, becoming the go-to source for the more than 500 mutual funds, hedge funds, and other institutions still trading CDOs, according to one person familiar with Citigroup’s operations. And because there was less competition in an illiquid market, the difference between what Citigroup paid for the bonds and what it sold them for was greater than in less opaque parts of the debt markets, the person says.
The bank also stocked up on inventory and profited when those positions rose in value. In the first years after the crisis, bargains were plentiful: Much of the CDO market traded at deep discounts. As home prices rebounded, borrowers refinanced loans or started making payments, and the securities recovered.
In some cases, Citigroup took steps to force gains by amassing senior positions in CDOs and unwinding the structure, getting access to the mortgage-backed securities inside that traded at higher prices, says a person with knowledge of the bank’s strategy. The trade has typically been a hedge fund strategy because banks face capital constraints, according to Grant Buerstetta, a partner at Blank Rome who specializes in the deals. “To get a deal unwound is a home run,” he says.
While it isn’t clear how much Citigroup made from marking up inventory, one thing is certain: By 2015 the bank had full control of the CDO market. It traded about $6 billion of the securities with roughly 150 customers that year, according to a person with knowledge of the operation. That amounted to about $700 million of revenue, or 80 percent of the market, says another person. The tally, more than 6 percent of the bank’s total from bond trading last year, was large enough to save the unit from reporting its worst performance since before the financial crisis. The team booked $700 million in 2013 and $500 million in 2014, that person says. The gains helped the larger securitized-markets operation run by Tsesarsky and Perlowitz tie for No. 1 on Wall Street, according to Coalition, a London-based research firm.