President Barack Obama's choice to lead the White House budget office oversaw a Citigroup unit that profited off the housing collapse and financial crisis by investing in a hedge fund king who correctly predicted the eventual subprime meltdown and now finds himself involved in the center of the U.S. government's fraud case against Goldman Sachs.
Jacob Lew, named Tuesday as Obama's nominee to lead the Office of Management and Budget to replace departing OMB chief Peter Orszag, served as chief operating officer of Citigroup Alternative Investments in 2008. He has served as a top aide to Secretary of State Hillary Clinton since the administration came into office.
Though Lew is a longtime public servant who's spent nearly 30 years in various positions throughout government, it is his few years at Citi -- in particular the one year he spent at its then-$54 billion proprietary trading, hedge fund and private equity unit -- that's likely to raise the most eyebrows in the coming weeks as Lew faces a Senate confirmation hearing.
Especially his unit's investments in a hedge fund that bet on the housing market to collapse -- a reality suffered by millions of American homeowners.
At the time, Citi's Alternative Investments unit was a $54.3 billion behemoth that participated in the kinds of activities that would be largely limited under the coming financial reform bill. The bill, which is expected to pass the Senate as soon as this week, contains the "Volcker Rules," named after their champion, former Federal Reserve Chairman Paul Volcker, which limits the amount of money banks can invest in hedge funds, private equity funds, and use to either invest or speculate in the financial markets. About 20 percent of the unit's available funds, or $11 billion, came from Citi itself (rather than clients), according to the bank's April 18, 2008, presentation to investors.
One part of the entity invested in hedge funds. Multi-Adviser Hedge Fund Portfolios LLC was a unit of Alternative Investments' Hedge Fund Management Group, the 36th-largest such "fund of hedge funds" in the world when Lew came aboard, according to a ranking by Alpha magazine, a publication that covers the hedge fund industry.
That Multi-Adviser fund in particular had $407 million by the end of 2007, a week before Lew was named as Alternative Investments' chief operating officer, according to SEC filings. At that time, it had $18 million invested in Paulson Advantage Plus LP, worth $26.4 million, comprising about 6.5 percent of the Multi-Adviser fund's total capital.
The Paulson fund was run by hedge fund king John Paulson, the man who made billions off the deterioration of the housing industry by making bearish bets on securities tied to home mortgages -- particularly subprime home mortgages.
One of those bets involved Goldman Sachs, Wall Street's most profitable firm and the target of multiple investigations and lawsuits stemming from its bets on the housing market and actions during the height of the financial crisis.
On April 16, the SEC charged Goldman and one of its employees for defrauding investors by creating and selling exotic securities tied to subprime home mortgages in 2007 without disclosing that they were handpicked by a hedge fund that was betting on them to fail.
That hedge fund was run by John Paulson. He has not been charged with any wrongdoing, nor is he likely to be.
During Lew's tenure atop Citi's Alternative Investments group, the Multi-Adviser fund significantly increased its investment in Paulson's fund, more than doubling Citi's investment to $41.5 million by March 2008. On paper the firm's investment was worth $55.2 million, accounting for 9.7 percent of the fund's total assets to rank as its second-biggest investment, SEC filings show.
The next quarter, the value of the investment jumped to $60.3 million, making it the biggest part of the Multi-Adviser fund.
By the end of September, the Citi fund, realizing some of its profits, took money out of Paulson's hedge fund. It's investment was down to $31.5 million, a $10 million decrease from June, but it was still worth $57.3 million, a mere $3 million less than June's appraisal, according to filings with the SEC.
By December 31, the value of Citi's investment jumped to $57.3 million, reflecting the declining fortunes of homeowners and other investors, and the economy at large. It now comprised 10 percent of the Multi-Adviser fund, making it the fund's biggest holding.
The Citi fund redeemed $13 million of its stake in Paulson's hedge fund by March 2009, bringing its investment down to $18.5 million -- roughly the same amount it was before Lew became Alternative Investments' COO. But that stake -- worth $26 million at the end of 2007 -- was now worth more than $50 million, SEC filings show.
Paulson's fund, Advantage Plus LP, went up 37.8 percent in 2008, according to Paulson's year-end letter to shareholders.
The Advantage Plus fund made its money thanks to bearish bets on financial institutions.
"[E]ight out of the top 10 banks on our list either failed, were recapitalized by the government, or were sold off to other banks as part of government-backed transactions," the hedge fund wrote to investors in its year-end letter.
Investors who bet on declines perform a productive role in financial markets. Such investments send signals to the markets that certain securities or valuations of certain companies or asset classes may be overvalued, perhaps tempering what may be too much enthusiasm that prices will continue to rise.
But in an age in which the housing collapse led to a financial upheaval that cost 8 million American jobs and plunged the nation into its deepest recession since the Great Depression, bets that profited off the collapse may not be perceived in the best light.
In Florida, Democratic Congressman and Senate hopeful Kendrick Meek is hammering his Democratic opponent, billionaire Jeff Greene, for his investments in securities tied to subprime mortgages, accusing him of profiting "off the backs of Floridians" who defaulted on their home mortgage loans. Greene reportedly doubled his net worth by betting against homeowners.
Citi paid Lew $1.1 million for his year at Alternative Investments, according to an ethics disclosure report filed in January 2009. He was also eligible for an undisclosed bonus. Lew did not immediately return a call for comment.
His unit, though, lost as much as billions of dollars in 2008 as its bets turned sour. In the first quarter of 2008 alone the unit lost $509 million; the company stopped publicly disclosing the unit's individual numbers soon thereafter, but the part of the company that absorbed Alternative Investments lost $20.1 billion in 2008, according to the bank's filings with the Securities and Exchange Commission.
Citigroup, the nation's third-largest bank, received $45 billion in TARP bailout funds that year. The firm also has issued $64.6 billion in taxpayer-backed debt through a crisis-era Federal Deposit Insurance Corporation program, according to its latest quarterly filing with the SEC. And it stands to gain a few billion dollars more by modifying home mortgages under the administration's foreclosure-prevention plan, Treasury Department figures show.
Lew's role at the fund is raising some eyebrows among good government groups.
"That sounds pretty nasty, doesn't it?" said Gary Bass, executive director of OMB Watch, a group that monitors the budget office. "Any activity and any player that contributed to the economic calamity needs to be looked at.
"We already got enough players in this administration that certainly were key players in the economic malaise that we currently have," Bass continued. "Why shouldn't we have another one?" he said with a slight chuckle.
But Bass added that he thought Lew was an otherwise excellent choice for the position, noting that as budget director Lew has a proven track record (he held the position during part of the Clinton administration).
During a January confirmation hearing before a Senate panel for his State Department post, Lew told senators that the investments his unit engaged in "ranged from private equity investments to real estate investments and various forms of fixed-income investments."
In December 2007, Citigroup Alternative Investments ended up supporting some of the bank's off-balance-sheet vehicles that tanked that year along with the subprime mortgage market. Known as structured investment vehicles, Citigroup effectively brought the SIVs onto its balance sheet by backing them up, leading to tens of billions in losses.
While putting him atop Treasury may have been a risky move considering his background, Bass said OMB would be a good fit -- particularly if he calls for more stimulus spending to combat the softening economy as opposed to insisting on deficit reduction.
Bass added that, given Lew's position overseeing a unit that invested in hedge funds, he'd like to know whether Lew believes that hedge fund managers should be taxed like other workers, as opposed to the relatively paltry share of income they give to Uncle Sam thanks to rules governing taxable income earned by private-equity and venture-capital firms, and hedge funds. Their compensation, part of which is earned on "carried interest," isn't taxed like regular wages because of their role in creating new investments.
The White House did not return a phone call and an e-mail seeking comment.
However, during his regular briefing with White House reporters on Tuesday, Obama's chief spokesman, Robert Gibbs, was questioned about Lew's tenure at Citigroup. Gibbs dismissed the queries, according to a transcript.
"Obviously, Jack has been through a vetting process before," Gibbs told a reporter who had asked whether Obama ever questioned Lew about his work at Citigroup. Gibbs eventually said he didn't know.
Asked if Lew's time at Citigroup was "relevant" and whether it would be "relevant" during his next confirmation hearing, Gibbs said that "those questions have been dealt with."
During that January 2009 confirmation hearing, Senator Johnny Isakson, a Georgia Republican, asked Lew if it was correct that he was COO of Citi's Alternative Investments unit (it was); what kind of investments the unit engaged in ("they ranged from private equity investments to real estate investments and various forms of fixed-income investments"); and whether those investments involved "much of international security trading" ("Lew said "not directly" and those that had an international focus "were really managed offshore"), according to a transcript.
There were no other questions about Lew's time at Citigroup.