24 November 2008

Citigroup Bailout Unwise

The Associated Press reported late Sunday that under the loss-sharing arrangement, Citigroup 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 financial bailout package approved by Congress 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.

As a condition of the rescue, Citigroup is barred from paying quarterly dividends to shareholders of more than 1 cent a share for three years unless the company obtains consent from the three federal agencies, AP reported. The agreement also places restrictions on executive compensation, including bonuses, it said.

Citigroup will issue $20 billion in preferred stock to government agencies, a move that would give taxpayers a benefit but could hurt existing shareholders. The preferred shares will pay an 8 percent dividend. . . . The immediate $20 billion capital infusion follows an earlier one — of $25 billion — in Citigroup in which the government received an ownership stake.

From here.

The Trouble With Guarantees

While there have been many bailouts during the financial crisis, this is one of the first big guarantee of assets that the government wasn't required to guarantee anyway that has stuck. A similar guarantee was proposed in a prior buyout, but overtime negotiations ultimately produced a deal that didn't include an asset guarantee.

In an equity purchase or loan, taxpayers can't be on the hook for more than the amount provided. It is a limited liability investment. This particular guarantee could cost the U.S. government more than $250 billion, but it appears that this $250 billion liability will not be counted against the $700 billion that Congress has authorized the Treasury to spend, even though the full faith and credit of the United States government is now obligated to make good on protecting the shareholders and bondholders of Citigroup from losses.

I have seen nothing to indicate that Congress anticipated the prospect of huge guarantees when it passed the bailout package. It contemplated purchases of troubled assets, and it contemplated loans or equity purchases, but not such a large contingent liability. Effectively, the Bush Administration is using asset guarantees to try to circumvent the dollar limitations that Congress placed on the bailout package with an accounting trick since guarantee liability is hard to value.

It is troubling that these deals, made with public funds authorized by Congress, are not disclosing what the American people are buying with their money. There is little or no indication of what kind of risk of loss the guarantee involves.

There are certainly some collateralized mortgage securities the government could choose to insure, for which Citibank's agreement to bear the first 9% of the loss constitutes almost all of the plausible risk of the securities. One could expect a loss that small on a bundle of mortgages with a significant minimum downpayment and better than subprime loans.

But, some collateralized mortgage securites are far higher risk. For example, it wasn't uncommon to get together a pool of mortgages and then sell them in ten tranches, with one tranch bearing the first 10% of the losses from the pool, and another bearing the last 10% of losses from the pool. If Citibank had significant first tranch investment in that kind of pool, those securities would be at high risk of having zero value.

Why Preferred Stock With No Strings Attached?

Like prior bailouts in this financial crisis, there are also no serious strings attached to how the lastest $20 billion of preferred stock funds can be used. This is a blank check investment. Certainly, there are dividend and compensation restrictsion that prohibit certain uses of any funds, but Citigroup has provided no plan of action (and apparently hasn't been asked to) to explain how the money will be used.

Unlike funds injected by the FDIC into troubled financial institutions to protect guaranteed depositors, which have priority in bankruptcy over the claims of stockholders, bondholders and other creditors, the preferred stock purchased in this case can't insist on payment of the interest due at a specific time in the near term, is an investment that is repaid only after all Citibank bondholders are made whole, provides no voting control, and doesn't appear to offer the kind of upside that a common stock investment would provide to taxpayers. It is a worst of both worlds form of investment.

The U.S. preferred stock investment does have priority in bankruptcy over common stock, but Citibank stockholders have already lost the lion's share of their investment as Citibank's share prices have collapsed in recent days, and didn't have any realistic expectation of dividends in the near future in any case.

No Upside

It is also troubling that there appears to be little upside benefit for the American people to a guarantee of a pool of toxic assets like this one. It isn't clear that the American people get anything but their money back with 8% interest on the latest $20 billion preferred stock buy (and $7 billion of immediate gain) and guarantee, if Citibank prospers. Indeed, the taxpayers seem certain to lose in any situation where the guaranteed assets lose 15% or more of their value, even if the company survives and the preferred stock are redeeed with interest.

In contrast, if the U.S. government had bought Citigroup's portfolio of $306 billion of collaterized mortgage securities at a deep discount, for example, for $240 billion, it would have limited Citigroup's losses while securing an upside for the U.S. taxpayer if the assets really are undervalued as a result of an irrational market panic, which is a key intellectual premise if the bailout in the form of an asset guarantee makes any economic sense. A purchase of troubled assets would also have given the U.S. a greater capacity to negotiate reasonable terms for people obligated to pay these mortgages who are in financial distress.

A Citibank relieved of toxic assets, but forced to take an immediate $68 billion loss, would probably survive, and even if it did go bankrupt, would probably continue as an enterprise outside of bankruptcy. But, now, if the U.S. was correct in betting that the toxic assets were worth more than the market would pay for them, it receives no benefit from this good judgment.

This contrasts with the Swedish solution:

Faced with a similar crisis in the 1990s, Sweden forced banks to write down bad loans, then the government injected liquidity into the system and profited from the upside after taking equity stakes in the banks.

Citigroup Financials

On paper, Citigroup doesn't have a particularly unhealthy balance sheet. Common stockholders had $99 billion in equity at the end of the September, and there was another $27 billion in preferred stock, about $25 billion of it from the last round of government bailout investments.

The market capitalization of Citigroup at the close of business on Friday, before the bailout was certain, was less impressive, at about $20.5 billion.

Even backers of the Citigroup bailout think that the taxpayers were screwed and that the stock isn't worth investing in, even after the bailout.


It appears that the loans break down as follows:

*The first $29 billion of losses from the portfolio will be absorbed by Citi entirely.
*The Treasury Department will take 90% of the next $5 billion of losses, with Citi taking the rest.
*The FDIC will step in and take 90% of the next $10 billion of losses while Citi absorbs the balance.
*Losses beyond that will be taken by the Federal Reserve in the 90% government role.

"Note that Citi is still supposed to take the remaining 10% at this stage but it's hard to believe that anyone really thinks Citi would be able to take any more losses once it had written down $40 billion more in this portfolio," Carney writes.

To the extent that this is a legitimate guarantee because the Fed is making the biggest part of the guarantee, and its losses are not public funds in precisely the same way as general appropriations, why is the Fed taking the lowest risk position in this deal? It takes losses only after the assets have been devalued by almost 15% and taxpayers have been hit with $13.5 billion of losses. It the real value of these assets is 80%-85% of their face value, the Fed may take a fairly small haircut on the deal, why the direct taxpayer involvement in the deal is maxed out.

Historically, the FDIC has protected depositors, but typically, banks have enough assets to make insured depositors, and indeed often all depositors, whole while still wiping out all shareholder equity and bondholders, because banks are such highly leveraged institutions.

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