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Citadel under siege, page 3

Last Updated: December 9, 2008: 3:54 PM ET

Credit default swaps on Citadel's debt and its leverage ratio became the next problems for the firm. They were now being quoted at distressed levels, meaning confidence in the firm's ability to back its bonds was at an all-time low. (Citadel has roughly $300 million in bonds outstanding after buying back about $200 million worth, and the bonds are rarely traded. Still, in mid-October, Standard & Poor's downgraded Citadel's bonds from stable to negative. On Nov. 18, S&P downgraded Citadel's bonds again, citing the firm's market losses.)

During October, Citadel also had to crush a rumor that appeared on a blog about its leverage hitting a ratio as high as 13 to one. According to the firm, the ratio was actually four to one (that means for every $1 of assets under management, Citadel had borrowed another $4).

Nevertheless, by that time smart fund managers had already drastically reduced leverage to almost zilch. The reason? They didn't want to fall prey to margin calls, forcing them to dump stock to repay the loans.

Citadel was getting some margin calls from lenders. But according to Gerald Beeson, Citadel's CFO and COO, the firm was able to pay the banks, which included Goldman Sachs (GS, Fortune 500), Merrill Lynch, and Deutsche Bank, with proceeds from its trading platforms and cash reserves.

"We became a story. That's not a good place for a financial institution to be. People may become incentivized to feed the rumors and take the other side of your positions, and some may try to push your portfolio against you," says Griffin, who believes there were traders trying to take his firm down. His persona as a Chicago-based maverick who had little time for the Wall Street Boys Club did not help matters.

"Ken has created a number of enemies on Wall Street," says a rival hedge fund manager.

Griffin set out to be generally independent of Wall Street. His business model was to create a diversified financial firm that did not rely on investment or commercial banks for trading or capital, which left Citadel with few friends in a world that requires fraternization through trading with one another, sharing information, dealmaking, and fee splitting.

"That very notion has pissed off a lot of people along the way," says the manager. (Recently, for example, Jamie Dimon, J.P. Morgan's (JPM, Fortune 500) CEO, temporarily refused to trade with Citadel after Griffin poached several top bankers.)

Regardless of its source, the gossip reached a tipping point during the week of Oct. 20, when the potentially lethal Fed bailout rumor surfaced. There were also reports that the Fed had been questioning Citadel's trading partners, asking them how much exposure they had to the firm.

Griffin acknowledges that the Fed did indeed question Citadel's trading partners, but he is quick to point out that the Fed was questioning all counterparties that traded with large hedge funds, not just his firm's, and that it was standard practice. But it was the Fed bailout rumor coupled with Forese's phone call that coaxed Griffin into the spotlight.

Despite some disagreement among Citadel's top management about conducting an emergency conference call, Griffin took Forese's advice, and his firm announced around 12:30 P.M. that very day, Oct. 24, that it would be staging a call primarily for its bondholders, but that the call would also be open to others.

Ironically, there was a major technical glitch for the firm, which prides itself on its technological prowess: The call was scheduled for 3:30 P.M., but because more than 1,000 people tried to pile on - investors, Wall Street, the press - Citadel's lines couldn't handle the traffic, causing a 25-minute delay. Those who got on the call were forced to listen to what one participant describes as "annoying techno music" during the wait.

Forese had told Griffin that there were two things he needed to convey on the call: "First, just get the facts out about your solid liquidity position. Second, you need to stem rumors about your survival."

The actual call was short - just 12 minutes. Griffin and Gerald Beeson assured the public it wasn't going under, telling them it had 30% of its investment capital in cash and an $8 billion credit line it could tap, among other things.

Says Beeson: "That next Monday when we came in, things were noticeably quieter. The conference call did stop the [press calls] and allow us to get back to work."

Sitting in the bar of the Four Seasons Hotel in New York with Griffin on a Friday afternoon - a day after watching him on C-SPAN, justifying his existence to Congress - is an odd experience. The past two months have felt like an entire year to him. True to his nature, he maintains a Zen-like calm, his cool blue eyes rarely blink, and he sips a glass of water as he talks about the lessons of the crisis.

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