In August 2007, an executive at Citigroup sent an e-mail message to a colleague warning of trouble in an obscure corner of the financial world: the $330 billion market for auction-rate securities.
"There are definitely cracks forming in the market," read the e-mail message, which is cited in a complaint filed last month by the U.S. Securities and Exchange Commission against a Citigroup subsidiary, Citigroup Global Markets. "Inventories are starting to creep higher in the market and failed auction frequency is at an all-time high."
In the following weeks, the problems in the market, which state and local governments across the United States relied on to raise money for public projects, became more acute. So did the alarm at Citigroup.
But that did not stop the bank from peddling the securities to investors and working with government agencies - including the Metropolitan Transportation Authority, which runs New York's subway, bus and commuter rail system - to bring more bonds into the already stressed market. With Citigroup Global Markets as one of its underwriters, the authority issued $430 million of auction-rate bonds on Nov. 7, 2007.
Almost immediately the deal soured. Interest rates on the bonds, set in weekly auctions, began to climb, to 4 percent from about 3 percent, and finally, by February, to 8 percent. By then, the entire auction-rate market had collapsed as panicked investors worried that they could not get access to their money.
Stunned by the soaring rates, which were costing it up to $560,000 a week, the authority redeemed the securities in March. To do so, it issued a new set of bonds, outside the auction system and at more favorable interest rates. But the move came with a cost: about $5.6 million in fees to bankers, lawyers and others, including the state, according to data provided by the authority.
All told, Citigroup earned more than half a million dollars on the two sales; Goldman Sachs, the authority's financial adviser, which counseled in favor of the auction-rate sale, made $929,500 for its work on both.
The transportation authority is now grappling with its worst fiscal crisis in decades, caused by plummeting tax revenues, rising expenses and a heavy debt load. To help plug a threatened $1.2 billion budget shortfall, it has proposed steep fare and toll increases for this year, as well as sharp cuts in service.
The SEC civil complaint charges that Citigroup misled investors and provides new evidence that the bank recognized early that the market was unstable but continued to underwrite and sell bonds.
Though the complaint does not mention the authority's bond sale in November 2007, it covers the bank's actions during that time.
Executives at Citigroup refused to answer questions about the transportation authority's bond deal; in a statement, the bank said, "Since the beginning of the auction-rate securities crisis, Citigroup has worked diligently with issuers, investors and regulatory authorities to work toward solutions."
Goldman Sachs refused to make an executive available to comment on its involvement. "Investor demand for this type of security was strong," the bank said. "Our market judgments and advice to clients were based on prevailing market conditions, which were far different from the unprecedented market dislocations in early 2008."
The complaint against Citigroup was filed in U.S. District Court in New York on Dec. 11, 2008, the same day a prearranged final settlement was announced.
Without admitting wrongdoing, Citigroup had settled the SEC complaint and other cases brought by New York State regulators, including the attorney general, Andrew Cuomo, agreeing to buy back more than $7 billion of securities from investors and to pay a $100 million fine. Other banks have agreed to similar settlements.
While the commission's complaint takes Citigroup to task, there is also evidence that the transportation authority - or its adviser, Goldman Sachs - should have seen warning signs, as other government issuers did. The authority's offering was one of the largest municipal bond sales in the months before the auction-rate market collapsed, according to data compiled by Ipreo, a financial services firm.
"We saw problems," said Richard Froehlich, the general counsel and executive vice president for capital markets of the New York City Housing Development Corp. That agency had used auction-rate bonds in the past, but as he prepared to sell more bonds in late 2007, Froehlich said he deemed them too risky. "There were dislocations that started in the summer of '07," he said. "After that, it was never our desire to go back into auction rate."
One transportation authority board member, Doreen Frasca, has voiced concern about some financing decisions, including why the authority stepped into the auction-rate market just as it was about to implode.
"I think there was a very surprising lack of foresight in reading the handwriting that was on the wall," said Frasca, who runs a consulting firm that specializes in airport finance. She joined the board after the auction-rate bonds had been redeemed.
Gary Dellaverson, the authority's chief financial officer, said he did not believe that he was misled by the bankers or the authority's financial adviser. He said that the experience with the bonds must be judged within the authority's overall borrowing program, which contained a predominance of fixed-rate debt and a smaller portion of less-expensive but riskier variable-rate debt. Over the past three years, he said, the variable-rate debt has saved the authority $150 million in interest payments, compared to the same debt in fixed-rate bonds.
"This was a calamitous disruption in the credit markets," Dellaverson said. "We managed our way through it."
Auction-rate bonds are long-term bonds with interest rates that reset at regular auctions, as often as once a week. Holders of the bonds would put them up for sale and investors would bid by designating the minimum interest rate they would accept.
But for an auction to be successful, all the bonds for sale on that date had to find buyers. If there were not enough bids at the right price, the auction would fail. For years, the banks had stepped in to keep auctions from failing by buying whatever bonds were not selling.
Citigroup had never allowed an auction to fail, according to the SEC complaint, a fact it advertised to assure clients of the market's soundness. But in August 2007, according to the complaint, demand for the securities began to weaken as investors sought safer places for their money. As a result, Citigroup had to invest increasing amounts to buy up bonds that had no other takers.
Typically, Citigroup kept $1 billion to $2 billion tied up in such bonds, the complaint said. But beginning that August, the amount began to increase. By February 2008 it was more than $10 billion.
The bank was facing other demands on its capital, partly because of bad bets it had made on subprime mortgages, and it knew it could not continue indefinitely to support the auctions, the SEC said.
In internal e-mail messages sent as early as August 2007, managers began raising the specter of letting auctions fail. Despite that, the bank kept underwriting new bond sales. According to the commission, Citigroup's investment bankers wanted to continue bringing new bonds to market to "earn fees and to maintain their position vis-à-vis bankers at other broker-dealers."
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