Federal Reserve Chairman Ben Bernanke (right) listens to President of the Federal Reserve Bank of New York Timothy Geithner before addressing the Economic Club of New York, in this October 15, 2008 file photo. (Lucas Jackson/Reuters)

This story was co-published with Politico.

As president of the New York Federal Reserve Bank, Timothy Geithner often preached that gargantuan financial firms like Citigroup should be held to the highest regulatory standards to make sure they couldn't take on too much risk.

But when it came to supervising Citigroup in recent years, the record shows that the New York Fed eased the reins as the company blew billions on subprime mortgages and other risky deals that ultimately forced the biggest bank rescue in U.S. history.

Now, the 47-year-old Geithner heads to the Senate in coming days as President-elect Barack Obama's nominee for Treasury secretary. He's won accolades for his expertise and work ethic, but there's been little attention to his record as a Fed watchdog.

Geithner's tenure at the New York Fed – which bore the major responsibility for supervising Citigroup – covers a tumultuous span in which the sprawling conglomerate spiraled from the country's biggest banking company to one of its largest welfare cases.

Now under much closer government supervision – after a $52 billion rescue – Citigroup appears headed for dismantling amid a leadership shuffle that included last week's announced departure of former Treasury Secretary Robert Rubin as senior counselor and director.

Should the New York Fed have seen trouble coming and prevented it? As Citigroup took on risk and its capital deteriorated, what oversight did Geithner exercise? And what contacts, if any, did Geithner have about regulatory matters with Citigroup officials, including Rubin, under whom Geithner worked at Treasury in the 1990s?

All are issues that may come up when Geithner appears before members of the Senate Finance Committee at his confirmation hearing, which has been put off until the day after Tuesday’s inauguration amid questions about Geithner’s taxes and past employment of a housekeeper.

Because the Fed conducts much of its work in secret, details about Geithner's role in the Citigroup debacle remain hidden. But a review of publicly available records shows that the New York Fed, in a key period, relaxed oversight as Citigroup went on a risky spree.

Geithner, following practice common among Cabinet nominees with pending confirmation hearings, declined an interview for this story. Neither the New York Fed nor Rubin responded to written questions about Citigroup.

The New York Fed's supervisory unit reports directly to the bank president, Geithner. The unit's job is to ensure that firms manage risk and have enough capital to cushion against losses. Large companies tend to be held to more stringent capital standards.

Yet poor risk management and weak capital levels were central to Citigroup's undoing. One enforcement agreement in place before Geithner took office in 2003 – an order requiring quarterly risk reports – was lifted during his watch. A ban on major acquisitions also was eliminated a year after it had been imposed in 2005.

Afterward, in 2006 and 2007, Citigroup aggressively expanded into the subprime mortgage business and bought a hedge fund and Japanese brokerage, among other assets.

A year later, as the global financial crisis took hold, Citigroup took losses and writedowns of more than $50 billion. The New York Fed brought no public enforcement case, although examiners privately sent a critical letter to the company in the first half of 2008.

Compared with its peers, Citigroup had a thinner capital cushion and relied more heavily on less-desirable types of capital, records show. The New York Fed knew – in 2007 it allowed Citigroup to count as capital securities that some regulators and credit agencies frown upon or discount.

Last May, after the collapse of investment firm Bear Stearns set off alarms, Fed regulators and Citigroup were in lockstep about risk and capital levels. "Perfect agreement" is the way CEO Vikram Pandit described it at a meeting with analysts.

A month later, Geithner gave a speech saying regulators needed to do more to make sure that companies had fatter capital cushions – but not until the financial system had stabilized.

Inheriting Citigroup

When Geithner was named president of the New York Fed five years ago, he was youthful but experienced. As undersecretary of Treasury in the late 1990's and later, at the International Monetary Fund, he was no stranger to problems in global credit markets.

Rubin, his former boss at Treasury, described Geithner to The New York Times in 2007 as someone with a "calm way" no matter the circumstance. Rubin, a senior counselor and director at Citigroup after leaving Treasury, called Geithner "elbow-less," referring to his widely recognized collaborative skills and easy manner.

Geithner inherited two Citigroup enforcement matters.

One, stemming from examinations in 2001 and 2002, involved allegations that Citigroup's consumer finance subsidiary converted personal loans into home equity loans without properly assessing credit risk. By May 2004, the Fed filed an action against Citigroup and ordered the firm to pay a record $70 million in penalties.

The other case involved Citigroup's role in helping Enron structure dubious off-balance sheet transactions that first propped up but later brought down the high-flying energy company. In July 2003, Citigroup agreed to pay $120 million to the SEC and entered into an agreement with the New York Fed to beef-up its risk management practices. Fed supervisors were to be informed of the company's progress every three months.

Citigroup's investment bank had run afoul of regulators around the world by 2004. Japanese supervisors forced the company to shut down a private bank. In Great Britain, Citigroup paid $25 million for an improper bond trading scheme, dubbed "Dr. Evil," that regulators said resulted from a corporate request "to increase profits by taking more proprietary market risk."

Higher risk can lead to more profit – or big losses. To cushion against the latter, financial firms must set aside capital, especially shareholder equity, or common stock.

Regulators closely watch a firm's "Tier 1" capital ratio, a percentage of stockholder equity and other stock against total assets, after risk adjustments. Regulators require a well-capitalized holding company to hold at least 6 percent Tier 1 capital, but very large firms or rapidly growing firms are expected to have significantly more.

Geithner made his views on the subject clear at a risk management forum in January 2005. He said the biggest firms needed "exceptionally strong" capital cushions and risk management systems because of their influential role in the financial system.

Citigroup's ratio exceeded 8.5 percent between 2003 and 2006, filings show. Although the company had a Tier 1 target of 7.5 percent, a top executive told securities analysts in 2004 it was "substantially more than what our risk analysis says we need."

As Geithner noted in his speech, the economy was "broadly positive" in 2005. But as Citigroup looked to grow, the Federal Reserve gave mixed signals.

In Washington, Citigroup was asking the Fed Board of Governors to let it buy First American Bank in Texas. The board assessed Citigroup's risk management in conjunction with the New York Fed and OK'd the deal in March 2005, concluding that controls were sound.

Taking note of the firm's problems abroad, however, the governors also put a hold on any "significant expansion" until Citigroup could enact a new risk and compliance plan it had developed to address the previous problems.

Citigroup was back in good graces a year later. After the head of bank supervision for the NY Fed wrote Citigroup indicating the company had made "significant progress" in managing risk, the pause on acquisitions was lifted in April 2006.

Then, the Friday before the Christmas weekend, the Fed announced that it had terminated the 2003 enforcement agreement and its requirement to file quarterly risk management reports. No explanation was offered.

Flurry of deals boosts risk

By then Citigroup was racing ahead at full speed. In 2006, Citigroup's issuances of collateralized debt obligations – securities in which mortgages and other debts are bundled and sold based on risk – grew to $40.9 billion, more than double the prior year. The number of subprime mortgages originated by Citigroup rose 85 percent that year, while other top originators had begun reducing subprime output, Fed data show.

Then the nation's largest banking company, Citigroup also began buying other financial firms. "They became very aggressive on the acquisition front, with a whole flurry of deals," said Joseph Scott, a senior director at the credit agency Fitch Ratings.

These deals pumped up Citigroup's balance sheet. Assets went from $1.2 trillion at the end of 2003 to $2.3 trillion by September 2007. But the bank's defenses weakened during the same period. By the end of September of 2007, records show, Citigroup's once comfortable Tier 1capital ratio had fallen to 7.32 percent, below the bank's target.

Geithner, in a 2006 speech on risk management, foresaw some of the troubles ahead. He said continued success required major institutions "to strengthen their capacity to withstand a less favorable" environment by better calibrating risk and capital.

Trouble became a reality for Citigroup by the end of 2007, when exposure to subprime loans caught up.

The bank's belated attempts to protect itself proved to be too little. Citigroup tried to hedge by purchasing credit default swaps and other instruments from insurance companies that themselves took on too much risk and couldn't cover all their contracts. That added billions to the company's record losses.

"They were late to hedge to begin with," said Scott, and "a lot of the hedging didn't work."

Other indicators of a flawed risk strategy surfaced in 2007. For instance, Citigroup repeatedly revised or "reclassified" its exposure to subprime losses, its definitions for accounting valuations and its reserve allowances.

Analysts say an inability to accurately account for losses is a sign of inadequate risk management.

A management shuffle in late 2007 led to the selection of Pandit, who helped run a hedge fund bought by Citigroup, as chief executive. He later concluded that what "went wrong" at Citigroup was a "tremendous concentration" in U.S. real estate deals.

Pandit quickly put in a new risk management team, a tacit acknowledgement that previous efforts failed. Last March a Citigroup director, testifying before Congress, was more direct: "We as an institution missed this pitch," said Richard Parsons, referring to mismanaging the risks of real estate lending.

Instead of enforcement, a strong letter

Around this time, examiners from the Fed wrote a letter to Citigroup very critical of its risk management practices, The New York Times later reported, citing an unnamed source. The Times report also said Citigroup responded with a plan for a sweeping overhaul of risk management. Although examination letters are part of the supervisory process, they are not considered enforcement actions, which carry more weight.

Scott, the Fitch senior director, called the firm's new risk team impressive, but "they inherited a lot of problems."

The problems cut into Citigroup's all-important capital base.

When it comes to valuing that base, regulators and credit rating agencies favor using common stock. But Citigroup, beginning in late 2007, relied increasingly on "hybrid" capital forms, such as trust-preferred securities, to prop up its Tier 1 ratio.

Even with these hybrids, its capital ratio dipped to 7.12, well below peers like JP Morgan Chase, at 8.44 percent, or Bank of New York Mellon, at 9.32 percent. In general, the NY Fed and the Federal Reserve allow the use of hybrid capital but apply limits and ask firms to obtain prior approval. In 2007, Citigroup exceeded the limit, the only bank among its peers to do so.

The Federal Deposit Insurance Corporation opposes the Federal Reserve's allowance of trust preferred securities for Tier 1 calculations. In 2005, when the Fed was drawing up the rules for trust-preferred securities, the FDIC argued that they should not qualify as Tier 1 capital because they are reported as debt on the balance sheet of banks.

Though the Federal Reserve is the primary regulator of Citigroup, the bank holding company, other regulators have jurisdiction over pieces of the firm and work closely together: the Comptroller of the Currency supervises Citibank; the FDIC insures Citibank's deposits; and the Securities and Exchange Commission oversees investment banks, like Smith Barney. As part of the bailout, Citigroup indicated it had previously entered into regulatory agreements with bank supervisors but did not disclose details.

When Citigroup executives spoke with securities analysts last May, they were questioned extensively about their capital adequacy.

By then Bear Stearns had collapsed, the result of too much subprime exposure, and had been swallowed up by JP Morgan Chase in a government-backed deal that Geithner helped broker. Analysts wondered if Citigroup and others faced such risk.

Surely, one analyst told Citigroup brass, you are being asked by your supervisors to hold more capital, given the market strife and the normal "tension" with regulators and auditors. Pandit, in reply, said there was no tension; all were in "perfect agreement."

The analyst said he didn't believe Pandit. But another Citigroup executive followed up, saying there was "unusual symmetry" with regulators and auditors.

In choppy seas, a tempered approach

A few weeks later, Geithner was publicly backing a cautious approach to building stronger capital margins and saying supervisors could not be omnipotent.

Speaking at a conference in New York in June, Geithner discussed the role of regulators in reducing risk or building capital, especially at major firms. He didn't mention Citigroup; regulators avoid talking about specific institutions.

It wasn't "realistic" to "expect supervisors to act preemptively to defuse pockets of risk and leverage," he said, but they could make the "shock absorbers stronger."

That meant "inducing institutions to hold stronger cushions of capital and liquidity in periods of calm."

But mid-2008 was not the time.

"After we get through this crisis and the process of stabilization and financial repair is complete," Geithner said, "we will put in place more exacting expectations on capital, liquidity and risk management for the largest institutions."

The crisis Geithner hoped would recede only got worse. Lehman Brothers went bankrupt, insurance giant AIG had to be rescued and credit markets froze up.

By far the biggest banking casualty was Citigroup. The firm received a $25 billion capital infusion in October, as part of the rescue plan Geithner helped engineer. That plan was designed to help "generally sound banking organizations." But the markets continued to lose confidence in Citigroup; its stock slid and its cushion of capital grew still thinner.

Last November, the government announced further aid for Citigroup under a new program for less healthy firms. The deal called for $20 billion in exchange for preferred securities, and a fee – paid by Citigroup – in the form of $7 billion more in preferred securities, for Treasury and FDIC to guarantee about $250 billion in bad assets.

A few hours later, President-elect Obama announced his selection of Geithner to replace outgoing Treasury Secretary Henry Paulson, with whom Geithner collaborated to design the government's program to bail out banks and Wall Street firms.

Rave reviews poured in from the street to Washington. One of the financial executives quick to praise Geithner was Citigroup's chief executive, Pandit.

"It's good to have him," he said.