Corporate & Securities Law

According to a recent BusinessWeek article, Citigroup, its clients and its brokers, are in the midst of several hedge fund flameouts and Citigroup is scrambling to hold on to both investors and brokers who are considering bolting from the firm.

As if Citigroup didn't have enough of a mess from its parade of writedowns, the bank must now deal with the fallout from blowups at a series of hedge funds.  Some of its high-net-worth clients, whose losses in the funds approach $2 billion, are threatening to move their money to rivals.  That's prompting some of Citi's top brokers to consider leaving the bank as well.

Citigroup is in damage-control mode, scrambling to stave off the exodus.  The bank recently pumped $661 million into six troubled hedge funds and devised a restructuring plan that would allow investors potentially to recoup some of their money.  The company is also arranging weekly conference calls with its sales force to keep them in check. 

The latest drama stems from six hedge funds - sold under the brand names ASTA and MAT - that used huge piles of leverage to buy municipal bonds.  The funds borrowed approximately $8 for every $1 raised.  When the muni market went haywire in February, the funds tanked.  Even after Citi's emergency cash infusion this year, they are down 60% to 80%.  The funds' rapid demise came on the heels of a plunge at the $1 billion Falcon Strategies, another group of highly leveraged funds run by Citigroup.  Late last year, the Falcon funds dropped more than 30% after making a bunch of bad bets on the mortgage market - declines that have continued into this year.

The problem started earlier this year when the municipal bond market got spooked by woes at the big insurers.  Prices on bonds, in turn, tumbled.  The volatility wreaked havoc on the funds, which sold short-term debt and used the proceeds to buy higher-yielding, longer-term municipal bonds - an arbitrage strategy that profited on the spread between the different yields.  The funds owned some of the hardest-hit muni bonds, those guaranteed by Financial Guaranty Insurance Co.; when the insurer lost its AAA rating, the prices on FGIC-backed muni bonds dropped precipitously.

The portfolios might not have been decimated if it weren't for all the leverage.  At their peak, the funds controlled some $15 billion worth of municipal bonds although they owned only $1.9 billion in investors' money.  But the mayhem in the munis triggered a round of margin calls, which forced the managers to sell assets to come up with cash to pay the funds' lenders.  Internal bank documents reviewed by BusinessWeek show that the largest of the municipal bond funds had lost almost all of its value by the end of February.  A spokesman for Citi, Alexander Samuelson, admits that the funds suffered from "unprecedented volatility."

It's not clear that Citi's recent moves will appease the two constituencies, brokers and investors, who have claimed that the municipal bond funds were pitched as low-risk.  One broker referred to them as a "failed product."  Another asserted that the restructuring plan will probably be a nonstarter with investors.

Already, at least one broker with a number of clients in the hedge funds has jumped ship to Morgan Stanley.  Sources familiar with the situation say other brokers have hired lawyers to negotiate separation agreements from Citi or to represent them if the bank tries to block them from defecting to another firm.  Some brokers are referring frustrated clients to lawyers and SNSFE stands ready to assist.

Please beware that sources indicate that Citi is trying to sweep the mess under the mat by requiring investors to agree that they won't sue the bank as part of the restructuring plan.

SNSFE continues to assist investors and investigate in hedge fund cases such as these.  Please contact us with any questions or comments.