David Ellis asks who might "fill the hole" in the investment banking world left by the collapse of Bear Stearns. The usual names get bandied about: Blackstone, JC Flowers and Citadel are the top contenders. All three have expanded into areas traditionally dominated by investment banks. And, as Ellis points out, in the not-so-distant past we've seen smaller firms--Lehman Brothers, for instance--grow into Wall Street powerhouses.

This kind of speculation is fun but it's important to remember that the brokerages and investment banks as we know them are largely a child of regulation that split commercial banking and investment banking. Many of those regulations have been reversed, which has helped lead to the consolidation we've seen in the past decade or so. What's more, investment banks may now face even greater regulation--and therefore higher barriers to entry--in the form of new regulations in exchange for access to the Federal Reserve's borrowing window. New capital requirements and leverage limits could reduce the profitability of investment banking, making it less attractive to new entrants. Ironically, the problems of the investment banks could wind up shoring up their market positions by stifling competition.

Perhaps the best case scenario is a that the coming regulatory schema could allow for a division of investment banks--with some opting for access to the Fed window in exchange for increased regulatory supervision and leverage-lowering capital requirements while others--perhaps up-and-comers like Citadel--opting to operate with more risk, more leverage and less oversight.

Filling the Bear Stearns void [CNN Money]

Whenever people talk hedge fund IPOs, the name Citadel inevitably comes up. The $20 billion firm found by Ken Griffin is sometimes described as an investment bank masquerading as a hedge fund, with diverse operations that go far beyond ordinary hedge fund operations.

And now it seems that the much talked about initial public offering may finally happen later this year. The latest issue of Business week reports the Citadel “would consider” an IPO. It’s not clear what it means that they “would consider” an IPO. Doesn’t that kind of mean they are considering an IPO?

The hoopla was started when Citadel CFO Gerald Beeson told BusinessWeek that an "IPO is something we'd consider. It would be a byproduct of our wanting to expand our firm to create an even more diverse and permanent institution."

A Hedge Fund's Savvy Ascent [Business Week]

So after the New York Post reported this morning that Citadel Investment Group had taken a look at Bank of America’s prime brokerage unit, Citdadel attempted to throw cold water on the story by denying it was in negotiations to buy the unit.

But don’t take this denial at face value. The Post reported this morning that Citadel "has recently inspected the books of BofA's prime brokerage business.” And the Citadel denial consisted of the statement that it is “not negotiating to buy” to buy the business. Which doesn’t mean they didn’t look at the books, consider buying it, have talks about buying it or even begin negotiating. Essentially, all the said was that they are not currently in negotiations.

What’s more, the denial comes from an anonymous source at Citadel. The spokeswoman, Katie Spring, declined to comment on the record. If there was nothing at all to the story, why wouldn’t Miss Spring deny it on the record? Bank of America also wouldn’t comment, which means they also haven’t denied shopping the prime brokerage or giving Citadel a look at their books.

None of this means that Citadel is buying the prime brokerage. But it does make the denial a little less plausible. Instead of “throwing cold water” on the Post’s story, it throws some smoke at it.

Citadel not eyeing BoA unit: source [Reuters]

Citadel is often described as an investment bank masquerading as a hedge fund. And it looks like it may be moving even further in the direction of becoming a full-fledged investment bank. This morning Roddy Boyd and Zach Kouwe report for the New York Post that Citadel is in talks to buy Bank of America's prime brokerage business.

It's not surprise that Bank of America wants to get out of its investment banking business. Ken Lewis made that clear earlier this year, and BofA has been shedding senior bankers ever since. According to the Post, both the head of the prime brokerage unit and the head of its fixed-income business have recently left.

But would hedge funds be comfortable putting their trades through with CItadel on the other end of the line? There is already resentment about the way some prime brokers take positions conflicting with those of their clients. JP Morgan has been sued by Amaranth over such conflicts and there are perennial complaints about Goldman Sachs. Still, both JP Morgan and Goldman make good coin with their prime brokerage business, so the talk about conflicts hasn't hurt them.

Still, there a plenty of folks who are suspicious of anything those boys with the white boards over at Citadel do. They have proven eerily apt at turning positions that ruin competitors into money makers. One hedge fund manager we spoke with this morning laughed out loud when we asked if he would run his trades through Citadel.

"Then again, they seem to know my positions and strategy anyway. So why not? Maybe they'll accidentally tip me off," he said.

Citadel, BofA In Brokerage Sale Talks [New York Post]

Earlier today we pointed out that the seventy-four percent discount on the asset backed securities Citadel has acquired from E*Trade will likely trigger a good deal of consternation on Wall Street. For the past few months banks and brokerages have been struggling to re-asses their credit portfolios. Even after a series of write-downs on those assets, many investors and market watchers remain unconvinced that the best and the brightest of the financial world understand the extent of their losses or are willing to be forthcoming about them.

The reason why Citadel's discount may have the bean-counters scrambling is that under new accounting standards—referred by those who enjoy talking in word and number jumbles as FAS 157 and FAS 159—companies are required to take into account easily available information about the market prices for their assets. With the Citadel trade blasted across Bloomberg screens and newspaper headlines, it's hard to argue that the information is not available.

What's more, one standard excuse for not writing-down assets should be unavailable. Under older standards, companies could claim that the assets had more value than could be achieved in a current market sale. No longer. These days companies are required to value even lightly traded assets in terms of the values they could achieve by selling or transferring the position. And that should mean they cannot blithely ignore the pricing of E*Trade's ABS portfolio.

It's still possible that other holders of asset backed securities on Wall Street will claim that E*Trades portfolio was especially weak or that they may continue to value the components of their own ABS portfolio as individual units rather than attempt to estimate the losses that would be incurred if a huge part of the portfolio was sold. This may provide some cover for the banks but it is not at all reassuring. We're told constantly that this latest round of write-downs has been the last, that the banks and brokerages are writing-down more than they need to because they have suddenly become conservative about such things. But if they put their heads in the sand—or, other dark places—and ignore E*Trade, we'll have to view these claims of a new conservatism on Wall Street with even more skepticism usual.

As has now been widely reported, Citadel has swooped down into E*Trade's coffers and delivered the internet bank and brokerage $2.5 billion in cash. Investors seem to like this deal, pushing up E*Trade's share price in early morning trading.

The lads and lasses at DealBook have a bit of a laugh this morning in a post titled "We're From Citadel, and We're Here To Help." They run through the now familiar litany of Citadel's quick asset purchases from distressed financial firms: Amaranth, Sowood, Sentinel. It would be tempting to describe these as bailouts by Citadel--indeed, DealBook reports that Citadel founder Ken Griffin pitches the deals as "helping" the troubled firms--except that each of the firms subject to Citadel's attention went on to sink even further. Citadel's help often seems to be a prelude to the ash-heap of financial history. E*Trade investors may want to take note: when Ken Griffin is on the phone, you are probably in more trouble than you think.

As part of the deal, Citadel is paying $800 million for asset backed securities that had a book value of $3 billion. That's close to a 74% haircut for E*Trade. It's worth paying attention to the possibly the secondary effects of this sale, which may be even more profound than most have acknowledged. The market for asset backed securities is one of those severely stricken in the credit crunch, and this trade is one of the few large, publicly announced sales of these assets in recent weeks. Surely those banks and brokerages which have been claiming to be adjusting their valuations to market realities will have to take a second look at their valuations in light of this 74% discount.

We're not exactly going to hold our collective breath waiting for the banks to mark their ABS portfolios down by two-thirds. If we listen close enough we can already hear them whispering in their conference rooms that E*trade's was a "firesale" and does not reflect underlying market fundamentals. Which makes us wonder whether they are truly confused about the difference between marking-to-model and marking-to-market.

We’re From Citadel, and We’re Here to Help [DealBook]

E*Trade to Get $2.55 Billion Cash Boost From Citadel [Bloomberg]

When Citadel hired John Andrews, Goldman’s head of investor relations, last month, as a managing director, everyone was all, “oooh, IPO,” “oooh, already stacking the deck for next year’s softball playoffs” (Andrews is supposed to be decent on the mound, I don’t know, we hear weird stuff). Bringing in Andrews, who Goldman signed in 1999, just before it went public, hints at Kenny’s intent to have his papers in order before diving into the public markets. If Citadel were going to stay private, hiring Andrews, whose expertise is in dealing with a wide range of public market investors would be kind of pointless. Some skeptismos said they would find an IPO hard to believe, given the recent turmoil in the credit markets. We hadn’t heard anything else in a while, mostly because we weren’t listening, but today we were told that at a dinner last night where Griffin was in attendance, a friend o' DealBreaker said that the manager “harped exclusively on taxation of public partnerships” and was “quite insistent that the "Blackstone bill" is a bad idea," making the FoD, "even more confident he's planning to IPO a piece of Citadel.” (Another DealBreaker reader-cum-dinner guest shared the less illuminating but more amusing tidbit that Griffin “tried- and failed miserably- to do that trick where you pull the table cloth off the table without moving any of the plates or silverware. The whole thing was really embarassing but it's not like you could do anything but try and stifle the laughter, 'cause he's Ken Griffin, you know?”) Anyway-- signs point to IPO or just good Samaritan Griffin trying to protect the $45 billion crab legs of private-then-public rich guys everywhere, himself not included? You decide.

Citadel takes a step toward going public [Fortune]

Confused cash management firm Sentinel deployed the “oops we had no idea what we were doing” escape pod late Friday, and filed for Chapter 11 bankruptcy. The firm, which, up until recently, managed about $1.6 billion of assets, said that it decided Chapter Once was in "the best interests of the corporation, its creditors and other interested parties that a voluntary petition be filed ... in an effort to restructure the indebtedness of the corporation." Obviously, Chapter 11 has its critics, namely those who regard it as an extremely lenient and easy out offered to incompetent management at a failing company, but in Sentinel’s defense, it should be noted that the firm really, really had no idea what it was doing.

For starters, no one at Sentinel had a vague idea which regulatory body to contact about halting redemption requests from investors. So it put a bunch of names in a hat, pulled out “CFTC,” and went with that. The CFTC turned out to be wrong, and a representative from the organization did not hesitate to tell Reuters: "The CFTC has no authority in this area. This isn't something we do.”

Then, on Friday morning, clients accused Sentinel of selling assets too cheaply—at discounts of as much as 30 percent to market prices—and without asking permission first to Citadel, who was more than happy to take them on, just as it was Sowood’s, and Amaranth’s, too. Apparently a U.S. district judge agreed that Sentinel acted improperly, and blocked the sale of some of the $312 million in assets to Citadel, with a temporary restraining order.

What's up next in Sentinel's bag of tricks, pratfalls and eggs-on-one's-face? Stay tuned.

Sentinel files for Chapter 11 bankruptcy [Reuters]

Sentinel, the troubled investment manager that, you'll recall, couldn't figure out which regulatory body to ask permission to halt a massive number of redemption requests earlier this week, is now probably going to be sued over allegations that it sold assets to Citadel without notice, and at discounts of as much as 30 percent to market prices. (Evidently, Sentinel made some calls and ascertained which entity actually holds the authority to freeze withdrawals, so hats off on that front).

Penson Worldwide, the securities-clearing firm taking issue with Sentinel's alleged breach of contract, said, "We believe that to liquidate such a portfolio at such a discount to market value constitutes, among other things, a reckless disregard of industry fair practice responsibilities by all parties involved," and estimates that it will lose $6.5 million unless the sale is reversed.

PW noted-with conviction-that it will "pursue all legal remedies." Going after a bunch of people who aren't even playing with a full deck, that we get. Fish in a barrel, those birds that were released for Cheney to kill. Easy. Pie. But don't fuck with something that Citadel is even tangentially part of. The Griffins have made a cottage industry of helping hedge funds that can't help themselves (Amaranth, Sowood, etc), and will be making their profit off of "unforeseen market volatility," "the idiocy of others," or "Brian Hunter," breach of contract or not.

Penson Says Sentinel Sold Its Assets to Citadel Without Notice [Bloomberg]

Bucking the trend that Harvard (Management Company) produces people with little use for air freshener and that love means never having to say you’re sorry, a “contrite” Jeff Larson spoke to clients yesterday during a ten minute conference call in which he tried to explain how their $3 billion investment shriveled up (but more so down) to about $1.4 in several weeks. (A few investors, new to the concept of the conference call, overzealously jumped in with their own answer: Shrinkage! A lack of masturbation! The Puerto Rican Day Parade! Coincidentally, these were all also incorrect but not unreasonable responses to the prompt “name three classic Seinfeld plots”).

Taking the “can’t argue with that” tactic, Larson began by offering, "You entrusted us with the management of your money, and we lost a lot of it, to say the least." He said Sowood borrowed heavily to make investments that the fund believed at the time were low risk and, as hedge funds are wont to do, backed them up with a hedging strategy the firm trusted to act as a lifeboat, in case anything went wrong. If you’ve been keeping up with all the episodes, you know that things did in fact go “wrong,” namely that the markets didn’t do what Sowood told them to do, rendering its hedges “ineffective.” Potted plants at best and even that’s reaching.

The ‘wood then tried to sell some securities, but that didn’t work out so well, either, because demand dried up and no one wanted to purchase sinking assets bought with mostly borrowed money. Spoiler alert: that wasn’t good. Larson said that he spent all of the weekend—yes, he gave up his weekend—negotiating a deal that would displace a complete and total disaster with just "a disaster."

"We did this in order to avoid what we believed was the very real possibility of counterparties seizing our collateral and liquidating or auctioning our positions," Larson said. He told investors that Sowood wanted to avoid the “high likelihood” of moving into a “little to no net asset value remains”-type situations, or as it’s called on the golf course, the James Cayne Surprise (everyone at home: this requires Saran Wrap and Silly Putty, and should only be performed by professionals).

If you want to talk numbers, Sowood lost 5% when its corporate debt portfolios got saggy in June, though no one with the firm thought it was a big deal. This would explain why July’s performance—in Larson’s words: “not just a repeat of June, [but] radically worse”—came as a shock.

"Each day brought greater and greater losses," Larson said. "A loss of this magnitude is as devastating to us as it is to you." The utter contrition almost makes you feel more sorry for the guy than the investors. (Is it real or exactly what the master of manipulation wants? You decide).

Earlier: Sowood Is So Sowwy

Sowood founder apologizes [Boston Globe]

The letter a hedge fund manager sends to his/her investors in the event of bad news like, say, a meltdown, etc., is an exercise in trying to jam a huge ego and an “I’m sorry, but I’m not really sorry, but I’m saying I’m sorry” onto one page. We’ve been calling him out a lot lately for what he’s done wrong, but one thing James Cayne did right was his memo to investors. As you well know, Cayne informed them that, contrary to what he and his colleagues had been pretending in the weeks previous, Bear Stearns’ two hedge funds were worth jack. As this charade was getting exhausting, and not because it’s wrong to lie, the big guy took it upon himself to come clean with the sad sacks (his words) who were silly enough to give Bear their money only to watch it be lit on fire. This would have all been rather unfortunate, Cayne went on, if it were going to hurt employee compensation at year end, which it won’t, thank god, so that’s pretty much it. Shipshape.

Sadly, Sowood Capital Management founder Jeff Larson has apparently not mastered the art of this particular love letter, and comes off as actually rather regretful and apologetic in the one he sent to his investors yesterday, re: selling “substantially all the funds’ [Sowood Alpha Fund LP and Sowood Alpha Fund Ltd] portfolio to Citadel,” which was more than happy to take them on. Larson even says “We are very sorry this has happened.” It’s actually all rather off-putting. Full letter (which seems to imply Sowood will be shutting down) after the jump.

Sowood Capital, blistered by big losses in its bond portfolio resulting from the current state of affairs in subprime mortgages and karma for Harvard being one of its biggest investors, voluntarily left the credit business today, after being asked to leave. The erstwhile multi-strategy fund, founded by Jeffrey Larson, sold its credit positions to Citadel, which now controls the “majority” of Sowood’s positions. Citadel manager Ken Griffin said in a statement this morning that his people “appreciate the professional manner in which the Sowood team has handled this complex transaction from start to finish.” Because when you’ve just completed the “transaction” of organ-harvesting, it’s nice to be gracious about it.

Sowood Unloads Credit Portfolio On Citadel [FINalternatives]

Fortune’s big “unauthorized” profile of Citadel boss Ken Griffin in now online and it delivers exactly the kind of slimy dirt you were hoping for. There’s the vague intimations that Amaranth’s collapse was something of an inside job. There’s the sentence which stops short of calling Anne Griffin a “trophy wife” but just barely (“He's got the trophy home, obviously, and is married to a very attractive woman, the former Anne Dias.”)

Most of all, however, there’s the assessment leveled by Third Point’s Dan Loeb, who “apparently refers to Griffin as a ‘gerbil,” according to Fortune writer Marcia Vickers.

Vickers goes on to reveal an email Loeb sent to Griffin:

In 2005, after Griffin snagged an analyst from another shop, Loeb sent an e-mail to Griffin: "I find the disconnect between your self-proclaimed 'good to great, Jim Collins-esque' organization and the reality of the gulag you created quite laughable. You are surrounded by sycophants, but even you must know that the people who work for you despise and resent you. I assume you know this because I have read the employment agreements that you make people sign." Citadel declined comment, as did Loeb.

Sure, Loeb wouldn’t comment. Sure.

A hedge fund superstar [Fortune on CNNMoney.com]

It's putting things a bit mildly to say, the the New York Post puts it, that "Goldman Sachs is raising eyebrows" with its disclosure that it has amassed a 7 percent stake in Ion Media Networks. Citadel and General Electric's NBC have partnered to target Ion for a buyout, and Goldman is advising NBC on the transaction. Information about potential buyout bids, of course, is not supposed to flow from the investment banking advising side to the proprietary trading side but the close timing of Goldman's Ion acquisition and NBC-Citadel's bid at least looks a bit dodgey.

So is Goldman leaking to Goldman, or is this just an inconvenient appearance of impropriety?

"It's really a matter of how far up the decisions go," one investment banking insider familiar with Goldman Sachs internal controls tells DealBreaker. "If the investment banking advice is coming from far enough down on the chain and the decision to pick up a big stake in Ion came from far enough down, it's probably just a coincidence. But the higher up you go, the narrower things get, and the harder it is for information not to get passed around."

There is, for instance, no "Chinese wall" bi-furcating Lloyd Blankfein's brain.

Goldman's Odd Moves [New York Post]

A lawsuit filed by Rush Simonson against Ken Griffin and Citadel has been dropped, according to the hedge fund. The suit, which alleged that Griffin had stolen a business plan that he and Simonson had developed together in the 80s, was voluntarily withdrawn by Simonson on January 17, without compensation for dropping it. Simonson’s lawyer had no comment about the withdrawal and Simonson himself “could not be located for comment,” according to Bloomberg. We’re kind of wondering why, just after Citadel posted gains of more than 30% (outpacing the hedge fund industry by 13%), Simonson would choose to drop his suit. Amidst the rumors that Citadel was the fund in the red, sure, we can see why you wouldn’t want to go to the trouble of getting dressed up for court just to be told the person you’re suing has no money, yes, that we get, but why now, when you know Griffin’s got the cash? Since Simonson (sketchily) “could not be located” to supply us with the answer, we’d like to hear your educated guesses. Did Simonson drop the suit because:

A. He was made to feel extremely uncomfortable by Griffin’s statement that:

``I have fond memories of my days in college when I would run back to my dorm room to execute trades on behalf of the partnerships we had formed…The filing of the lawsuit left me feeling betrayed by my former business partner.''

Citadel Investment, Griffin Say Lawsuit Is Dropped [Bloomberg]

Remember, back in November, when there were all those rumors about a hedge fund in trouble, and even though Citadel vehemently—almost suspiciously so—denied that it was them, people were still kind of like “Sure, it’s not you, Citadel, we believe you” wink, wink? Apparently, according to Bloomberg, they weren’t bluffing. (SAC Capital pretty much cleared its name, too, but who cares about looking good to other hedgies when you've got a $54 million party-foul to deal with?)

Hedge funds run by Steven Cohen and Kenneth Griffin gained more than 30 percent last year, the industry's best performance since 2003, while Goldman Sachs Group Inc.'s flagship fund declined for the first time in seven years.

Cohen's SAC Capital Advisors LLC returned 34 percent and Griffin's Citadel Investment Group LLC also topped 30 percent, helped by energy bets it took over after Amaranth Advisors LLC collapsed in September, according to investors in the funds. Goldman's Global Alpha Fund ended the year with a 6 percent loss.

Citadel, SAC Funds Double Returns of Peers as Goldman Declines [Bloomberg]

Today’s edition of Platt’s Energy Trader takes in depth look at how Citadel and JPMorgan took over Amaranth’s energy portfolio, turning Amaranth’s losses into profit. The basic outline of the story is that after gas prices sank and the spread between March 2007 and April 2007 natural gas futures shrank, Amaranth found itself in the troubling position of having to sell off assets, in part to meet the margin calls of its broker, which happened to be JP Morgan. Citadel and JP Morgan then teamed up and bought the portfolio at a steep discount—a move that some at the time thought looked like a bailout of Amaranth.

As it turned out, Amaranth collapsed anyway. It’s energy trading desk was at the heart of its operations, and after the meltdown it had little hope of going on. And the “bailout” was anything but an act of charity or an LTCM-style attempt to shore up market stability. JPMorgan and Citadel had their eyes keenly on the prize—profits. In a matter of weeks, JPMorgan turned around and sold it’s half of the Amaranth position to Citadel, pocketing a cool $750 million.

It must be nice to be a JPMorgan prime brokerage client. First they squeeze you on the margin call, then scoop up your assets and make $750 million by selling them. Wonder how Amaranth founder Nick Maounis feels about JPMorgan these days.

Here’s how Platt’s describes Citadel’s side of the bargain.

Citadel acknowledged that there is still substantial risk connected to the remaining Amaranth trades, and it set aside cash reserves to cover those risks. “These reserves reflect the illiquidity of the portfolio and the operational risks involved in the initial assumption of the portfolio,” Citadel said.

Citadel said it expects to have eliminated those risks, and the need to reserve funds, by the end of the year.

Which is to say, Citadel expects to have fully turned-around the trades that brought down a large and long-standing hedge fund in a matter of three-months. Like we said earlier, damn it’s good to be Ken Griffin.

Well. That certainly didn't take long. Citadel sold the first batch of notes on its debt offering, pulling in $500 million, according to a source cited by Bloomberg. Damn it must feel good to be Ken Griffin.

Citadel Investment Group LLC, the hedge fund controlled by Kenneth Griffin, sold $500 million of five-year notes today in the first-ever sale of bonds by a hedge fund, according to a person familiar with the transaction.

The fund sold the notes at a yield of 1.90 percentage points more than similar-maturity Treasuries, said the person, who declined to be identified because the sale is private. The average yield premium, or spread, on similarly rated notes is 1.22 percentage points, according to data compiled by Merrill Lynch & Co.

The sale by Chicago-based Citadel may allow it to rely less on financing from Wall Street investment banks. The bonds will be sold through a medium-term note program.

JPMorgan may have hauled in as much as $750 million from the trades it took over from Amaranth, according to a story in Investment Dealers’ Digest. That’s pretty good for a position JPMorgan held for just a few weeks before handing it off to Citadel.

But even more importantly, the IDD story provides the outlines of what we’ve come to think of as the Amaranth Conspiracy Theory (ACT for short).

In its third-quarter earnings call, JPMorgan said it profited by taking over Amaranth's natural-gas positions. JPMorgan did not disclose how much it made, but according to one senior commodities executive at a JPMorgan rival, the bank earned $750 million on the trades. A JPMorgan spokesman declined to disclose the size of the bank's windfall.

JPMorgan earned money from Amaranth's losses by purchasing the hedge fund's natural gas positions when prices were under pressure and the fund was forced to liquidate to meet its margin requirements. When prices rebounded, JPMorgan reaped the benefits.

The eyebrow-raising part, for some observers, is that JPMorgan was prime broker to Amaranth and so was presumably the one doing the forcing. "I don't know if they did anything wrong, but when you pull the plug on a company and make a lot of money, it's a bit curious," says Berman (a lawyer for some Amaranth investors). The JPMorgan spokesman declined to give details on the dealings between Amaranth and the bank.

You get the idea: Amaranth didn't fall off a cliff. It was pushed.

Amaranth Fallout Could Hold Surprises [Investment Dealers' Digest subscription only]