Will Clients and Brokers Bolt?

As if Citigroup (C) 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. "I don't want any of you to think that we have underestimated the impact of this on you or your clients," Sallie L. Krawcheck, chief of Citi's Global Wealth Management, told brokers in a call on Apr. 2. "This is the most important issue we have been dealing with [in the group]."

Muni Meltdown

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.

It's not clear that Citi's recent moves will appease the two constituencies, who have claimed that the municipal bond funds were pitched as low-risk. One broker referred to them as a "failed product" in the Apr. 2 call. 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 funds has jumped ship to Morgan Stanley (MS). Sources familiar with the situation say others 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. David A. Weintraub, a securities attorney who represents two Citi clients, says the bank is trying to "sweep the mess under the mat" by requiring investors to agree that they won't sue as part of the restructuring plan.

A Bright Spot Dims

Citi isn't the only bank facing the wrath of investors and brokers. Bear Stearns (BSC) was quietly settling with some of its wealthiest clients who had invested in two failed hedge funds in the weeks before JPMorgan Chase (JPM) agreed to buy the firm. Bear also recently sued a broker who bolted amid the bank's collapse. A spate of failures in the $300 billion market for short-term investments known as auction-rate securities has sparked investor lawsuits at UBS (UBS), Merrill Lynch (MER), and Lehman Brothers (LEH).

But the revolt is especially troubling for Citi. The brokerage business has been one of the few bright spots. Profits in global wealth management jumped 37% last year, to $1.4 billion. It was the only division to show growth.

The problems 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. (FGIC); when the insurer lost its AAA rating, the prices on FGIC-backed muni bonds dropped precipitously.

'Unprecedented Volatility'

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 only had $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. Alexander I. Samuelson, a spokesman for Citi, says the funds suffered from "unprecedented volatility."

Citi moved quickly to shore up the municipal bond funds with a huge cash infusion. As part of the restructuring plan, the bank has agreed to give up much of the future gains on that capital to investors. At the same time, Citi has structured the deal so clients won't suffer any further losses. Even so, more than 2,000 of the bank's wealthiest clients are out the majority of their initial investment.

Some investors say the risks of the funds weren't apparent. Despite written materials that outlined the use of leverage and other red flags, Weintraub, who represents several Citi investors in the ASTA and MAT funds, says brokers pitched the products as a "conservative" alternative to traditional bond funds, prompting some to pile into the funds aggressively. He adds, "I've seen significant portions of investors' net worth tied up in these products."

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