Can anyone run Citigroup? (page 3.)

Gary Crittenden, whom Prince hired from American Express to be chief financial officer and who is much respected around Citi, told Fortune in March that, out of caution, the company intentionally raised more capital than its balance sheet immediately required. This cushion came to look like a lifesaver as Citi issued its results for the first quarter of 2008.

The company took new writedowns of more than $12 billion on CDOs and other assets. (Citi's quarterly earnings report appeared just as this article went to press.) Meanwhile, Citi has been reducing its need for capital by selectively selling properties. In April, for instance, Citi announced it would sell (for an undisclosed amount) most of its North American commercial lending and leasing business to GE Capital, in a deal involving the transfer of $13 billion in assets.

A notable omission in Pandit's capital recital was any talk of the capital-conservation move he made in January: cutting Citi's dividend by 41%. But that blow is naturally fixed in the minds of many shareholders, loads of them current or former Citi employees who, under a policy beloved by Weill, got large chunks of their pay in Citi stock. For all shareholders, the dividend drama continues.

Oppenheimer analyst Meredith Whitney, who forecast the first dividend cut and who has generally been a scourge about Citi's finances, is today predicting that Citi will eliminate its payout entirely. (Weill, by the way, says he is still a "large shareholder," though he doesn't care to define that further. At last official notice, in February 2006, he owned almost 20 million shares, which at the time were worth about $900 million. His co-CEO, Reed, has said he himself cashed out $287 million in stock options in 2000, the year he left the company.)

The fact that so many Citi employees have taken their lumps on their stock implicitly connects to Pandit's second imperative. To protect the company's earnings power, he says, Citi paid its employees well for their 2007 work - true, not as well as if there'd been no losses, but enough for them to feel appreciated. He's talking year-end bonuses and the like, and they hardly went to all 380,000 people. But still, they may have helped lift morale within Citi, which many employees describe as terrible.

The third imperative - no surprise- concerns the troubled assets on Citi's books: CDOs, leveraged loans, and the SIV positions. "We've tried to put a ring fence around these assets," says Pandit. "We've been completely focused on bringing these down and managing them as well as we can for our shareholders." In the latest sign of motion, Citi agreed to sell $12 billion of leveraged loans to institutional buyers, at a price probably around 90 cents on the dollar. That's only a portion of the $42 billion in leveraged loans that Citi carried on its year-end books or was committed to finance, and more loans may be sold soon. One institutional buyer reported that in the wake of the $12 billion sale, Citi was busy hawking six more loans, one of them made to Chrysler.

Trading in CDOs is virtually nonexistent today, because they're too complicated for buyers to value (which of course they always were, even when buyers loved them). Pandit says, however, that in some cases the collateral that underlies CDOs is moving, and in other cases the CDOs have been marked down to a value so low that selling them wouldn't exactly make sense. The whole problem about stuck assets makes him sharply aware that the world is seeing a reversal of the powerful securitization trend that for the past 20 years swept assets off bank balance sheets. The idea then, he says, was to distribute risk, and today, in contrast, assets must be increasingly retained by the lender that brought them to the party. "Going through a transition that significant in a very short period of time," Pandit says, "is what's creating the dislocations in the market."

The biggest figures in Citi's 10-K relate to derivatives, in which Citi is a huge player. Take credit default swaps (CDSs), which are derivatives contracts by which a holder of a bond, say, can transfer the credit risk of owning it to another party. At the end of 2007, Citi was on one side or the other of $3.7 trillion in CDS contracts. Worldwide there were $62 trillion of such contracts outstanding, so Citi was accounting for a gut-wrenching 6% of the market. Even a tiny swing in the value of Citi's CDS positions would deliver a loss or gain of several billion dollars.

Collateral backs many CDS contracts, but not all. The potential problem - for all derivatives and especially in a credit crunch - is that a counterparty may fail to live up to its end of the bargain. As it entered its March crisis, Bear Stearns, an important participant in the derivatives market, looked like a counterparty about to fail, and that's a central reason the Federal Reserve leaped in: to prevent the contagion that is called "systemic risk." Advocates of derivatives used to say they beneficially spread risk, but no one seems to be campaigning on that platform today.

All of this is pretty much Math 101 for Pandit. A "quant" by instinct who trained as a Morgan Stanley trader, he is an acknowledged risk expert who fits the notion that the CEO of a financial company should in effect be its chief risk officer (a job not tailor-made for lawyer Chuck Prince).

NEXT: Can anyone run Citigroup? (page 4.)

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