Monday, November 24, 2008

Citigroup Bailout Fiasco

Too Big To Fail?: While Wall Street and stock investors smile with relief, Main Street grimaces in pain. The government plowing $20 billion into Citigroup to forestall collapse is another example of throwing good money after bad. President Bush and his economic advisers said the company is too large to fail. "It would create chaos," said Winson Fong, managing director at SG Asset Management in Hong Kong, which oversees about $3 billion in equities in Asia. "Simply put, you couldn't borrow or lend for a while. This is a nightmare scenario." That it is. But, let's take a look at what Citigroup did to create its own manure pile. Let's examine the latest Citigroup bailout proposal by the feds. Finally, let's explore the possibility it won't work.

Big Is Better: Former CEO Sanford Weill built Citi into the largest U.S. financial institution and left it in the hands of incompetent management. Writes Steven Pearlstein in Monday's Washington Post:
  • It was Weill who orchestrated bringing down the old regulatory wall that had separated commercial banking from investment banking and insurance. The combination of Citibank with Solomon Smith Barney under the bright red umbrella of Travelers Insurance was accepted with a regulatory wink and nod by the Federal Reserve while then-Fed Chairman Alan Greenspan worked to persuade Congress to make it legal by repealing the Glass-Steagall Act, put in place during the Great Depression to prevent another market crash like that of 1929. For no sooner had Weill stitched together his empire than it began coming unraveled as a result of a series of soured investments and embarrassing ethical scandals that cost shareholders tens of billions of dollars. In the years since Weill's departure, as various pieces of the company have been sold off or closed down, it has become obvious that the promised economies of scale had been overhyped, the synergies across business lines had never developed and the cultures and systems of the various parts had never meshed. The whole thing was simply too big and too complex to be managed. It has also proved too big to be regulated. Over the past 20 years, the Federal Reserve, Citi's chief regulator, has been unable to get a handle on the bank's excessive risk-taking and incessant corner-cutting. Time after time, Citi rushed to jump aboard the latest gravy train -- developing country loans, commercial real estate, Internet stocks, subprime lending and securitization -- and time after time, Fed regulators failed to spot a problem until it was too late.

The Bailout: Citi has $2 trillion in assets, more than 300,000 employees and operations in 100 countries. The capital infusion follows an earlier one — of $25 billion — in Citigroup in which the government also received an ownership stake. As part of the plan, Treasury and the FDIC will guarantee against the "possibility of unusually large losses" on up to $306 billion of risky loans and securities backed by commercial and residential mortgages. Under the loss-sharing arrangement, Citigroup Inc. will assume the first $29 billion in losses on the risky pool of assets. Beyond that amount, the government would absorb 90 percent of the remaining losses, and Citigroup 10 percent. Money from the $700 billion bailout and funds from the FDIC would cover the government's portion of potential losses. The Federal Reserve would finance the remaining assets with a loan to Citigroup. In exchange for the guarantees, the government will get $7 billion in preferred shares of Citigroup. In addition, Citi said it will issue warrants to the U.S. Treasury and the FDIC for about 254 million shares of the company's common stock at a strike price of $10.61. In the most self-serving understatement of the millennium, current Citi CEO Vikram S. Pandit said in a statement issued early Monday:"We appreciate the tremendous effort by the government to assure market stability."

Will It Succeed?: The evidence is grim the fed bailout of our financial sector is working. Since the housing market collapse two years ago, $4 trillion in housing wealth and $9 trillion in stock-market wealth has been destroyed. "There is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values," writes Christopher Wood in an op-ed article in Monday's Wall Street Journal. He makes a startling observation Main Street understands:

  • The Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September. But the growth of excess reserves also reflects bank disinterest in lending the money.

  • (Federal Reserve Chairman Ben) Bernanke and others blame Japan's postbubble deflationary downturn on policy errors by the Bank of Japan. But he and others are about to find out that monetary gymnastics are not as effective as they would like to think. So too will the Keynesians who view an aggressive fiscal policy as the best way to counter a deflationary slump. While public-works spending can blunt the downside and provide jobs, it remains the case that FDR's New Deal did not end the Great Depression.

  • Meanwhile, the most recent Fed survey of loan officers provides hard evidence of the intensifying credit crunch in America. A net 83.6% of domestic banks reported having tightened lending standards on commercial and industrial loans to large and midsize firms over the past three months, the highest since the data series began in 1990. A net 47% of banks also indicated that they had become less willing to make consumer installment loans over the past three months.

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses.
The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.
News Flash: Dow Industrials spiked 300% this morning based on the government's cash infusion plan for Citigroup. Stock price of Citi rose 59% to $6.95. Investor confidence? Try selling that to the guy on Main Street seeking a loan from Citi or the other cash-infested fat cats.

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