Matt Yglesias

“Private” Investors in Citigroup

From a Wall Street Journal article on possible plans for a larger federal ownership stake in Citigroup:

Under the scenario being considered, a substantial chunk of the $45 billion in preferred shares held by the government would convert into common stock, people familiar with the matter said. The government obtained those shares, equivalent to a 7.8% stake, in return for pumping capital into Citigroup.

The move wouldn’t cost taxpayers additional money, but other Citigroup shareholders would see their shares diluted. A larger ownership stake by the federal government could fuel speculation that other troubled banks will line up for similar agreements. [...] As part of the plan, Citigroup officials hope to persuade private investors that have bought preferred shares — such as the Government of Singapore Investment Corp., Abu Dhabi Investment Authority and Kuwait Investment Authority — to follow the government’s lead in converting some of those stakes into common stock, according to people familiar with the matter. That would further bolster an obscure but increasingly pivotal measure of banks’ capital known as “tangible common equity,” or TCE.

Words like “Government of” and “Authority” when paired with the names of countries are usually indications that we’re dealing with government entities, not private ones. The upshot of this would be to turn Citigroup into a company that was, in essence, jointly owned by a few different governments.

A Viable Alternative to Nationalization?

Brad DeLong recommends this plan from Susan Woodward, Robert Hall, and Jeremy Bulow as “the cleverest plan I have yet seen.”

And, indeed, it is clever. Here’s the plan in chart form:

The other two columns show the balance sheets of the new good bank and bad bank. The good bank will continue to operate under the Citi brands as a well-capitalized operating entity. The bad bank will be a financial fund with no operating functions. The good bank gets the short-terms assets and the “other” assets because many of these are related to its operating activities. It gets the better half of the long-term assets, taken to have book value, while the bad bank gets the poor half, where the impairment has already occurred and suspicions of further price declines persist. The bad bank holds the valuable equity in the good bank to the tune of $427 billion.

The deposits remain as liabilities of the good bank. Because the good bank is heavily capitalized, the deposits are safe. Most are uninsured, so the creation of the good bank eliminates the danger of a run on the bank by those depositors. All of the debt goes to the bad bank. The holders of the debt were never promised a government guarantee. The shareholders in Citicorp become the shareholders in the bad bank. They are indirectly shareholders in the good bank as well, because the bad bank owns the good bank.

The bad bank is thinly capitalized. In fact, it has exactly the same amount of capital that Citi had in the first place. With further declines in the values of the troubled assets, the bad bank may become insolvent. In that case, the bondholders will need to negotiate diminished values or the bad bank will need to be reorganized. In either case, the shareholders will lose all their value, just as they would have lost that value had Citi not been divided and there had been no further bailout from the government. The bondholders will lose part of their value, because there is no reason or justification for bailing them out.

This seems suspiciously like magic, so I’d like to know what others with some expertise have to say.

The Life of Citi

I didn’t know this bit of Citibank history:

But I will say that if the recent history of our financial system tells us anything, it’s that it’s a miracle (and not in the good sense) that at least one bank—Citigroup—hasn’t already been taken over. This is a bank that was, by most accounts, technically insolvent in the early nineteen-eighties, as a result of the Latin American debt crisis. It was in serious trouble again in the early nineteen-nineties—Congressman John Dingell actually gave a speech in 1991 saying it was insolvent. And it’s been a major player in, and cause of, our current financial crisis, with a chorus of analysts declaring that, once again, its liabilities are greater than its assets. It does make you wonder how many lives it has, and it also makes you wonder why, after its earlier woes, regulators ever allowed it to get this big.

It seems to me that encouraging the growth of ever-larger financial institutions has actually been part of the regulatory strategy for avoiding ever needing to do something like seize Citigroup. When a bank’s in big trouble, one way to resolve the trouble is to fold it into something bigger. But now Citi’s gotten so big that only the federal government is big enough to provide a workable fix.

Meet The New Jet

Citigroup may be an insolvent zombie bank whose stock only has any value because investors are willing to bet on the possibility of a government bailout, but that’s not stopping them from buying a $50 million new corporate jet:

Even though the bank’s stock is as cheap as a gallon of gas and it’s burning through a $45 billion taxpayer-funded rescue, the airhead execs pushed through the purchase of a new Dassault Falcon 7X, according to a source familiar with the deal. [...]

“Why should I help you when what you write will be used to the detriment of our company?” replied Bill McNamee, head of CitiFlight Inc., the subsidiary that manages Citigroup’s corporate fleet, when asked to comment about the new 7X.

“What relevance does it have but to hurt my company?”

As an example of the difference between nationalizing a bank as part of a rescue package and simply getting its toxic assets “off the balance sheet,” in a nationalization scheme the taxpayers whose money is paying for the jet would also own the jet and be in a position to sell it off. Under a Classic TARP plan you pay for the jet, but Citigroup’s shareholders own the jet, and Citigroup’s managers get to use the jet.

Meanwhile, whenever you see these jets, keep in mind that (a) first class airfare is incredibly expensive, (b) first class air fare is cheaper than corporate jets, (c) first class airfare is very posh, (d) any company that needs a special subsidiary to operate its fleet of jets needs a union so as to redistribute some of the surplus away from managers and toward lower-level employees.

Breaking Up Citi?

Felix Salmon says it’s time to find an orderly way of pulling the plug:

The other bit of good news is that Citi’s domestic retail bank is relatively small, by BofA/JPMC/Wells standards. A buyer could be found for it relatively easily; if no US bank wants to step up, there are always the Canadians, or maybe Santander.

The Smith Barney wealth-management operation is already halfway out the door; the investment bank could be sold to its own managers, much like Neuberger Berman. The credit-card operations and Banamex could be IPOed; the Polish bank could go to any number of European banks looking to expand east of Germany.

I’m sure there would be feverish bidding for the hugely valuable Citigold brand globally; once Citi’s Japanese operations were sold off, the rest of Citi’s global presence could either be absorbed into the investment bank or quietly sold off or shut down. I’m sure there are other bits and pieces I’m forgetting about here, but the point is that on a sum-of-the-parts basis, Citi’s actually got some pretty valuable assets; the problem is of course on the liability side of things.

So either the government outright nationalizes Citigroup and then sells it off, or else it provides debtor-in-possession financing within some kind of Chapter 11 proceeding.

Either way, the world would see the failure of a too-big-to-fail bank, and that would in turn be salutary for anybody still trying to make money from the moral hazard trade.

I’m a little bit skeptical that you really could sell off all that stuff in the current climate. Or, at a minimum, that you might not be able to sell off significant chunks of it. But when you talk about a Swedish-style nationalization scheme, the plan is always to sell off as much of the nationalized assets as quickly as possible. The idea is that with the government in control, it can sell enterprises that have value, recapitalize enterprises that would be saved by recapitalization, and kill off enterprises that can’t be saved through any kind of feasible injection of capital. The goal isn’t to have the government running all the banks permanently, it’s to create a situation where people know that the banks are sound. In particular, where they know that the banks that have been rescued have really been cured rather than just put on life support. At the moment, nobody knows which banks’ demise has really been avoided and which merely forestalled.

Sweetheart Deals

I’m prepared to be convinced that some form of assistance for Citigroup was necessary, but this looks like a sweetheart deal to me:

The 11th hour transaction, announced just before midnight on Sunday in the US, calls for Citi to absorb the first $29bn in losses it sustains from its portfolio of risky assets – from residential mortgages to commercial real estate and leveraged loans, collateralised debt obligations and auction rate securities. Federal government entities will stand behind 90 per cent of the remaining losses, which could amount to $249bn. [...]

Under the terms of the arrangement, the US Treasury will invest $20bn in Citi preferred stock under the federal government’s troubled asset relief programme (Tarp) and receive dividends at a rate of 8 per cent annually. On top of that amount, Citi is receiving an additional $7bn in return for preferred shares issued to both the Treasury and the Federal Deposit Insurance Corporation for their roles in guaranteeing the risky assets. [...]

Gary Crittenden, Citi’s chief financial officer, said that last week’s plunge in the bank’s share price, from $9.36 last Monday to $3.77 at Friday’s close, was “very concerning.” At Friday’s share price, the bank’s market capitalisation stood at a mere $20.5bn, according to Bloomberg.

If I understand this correctly, the government just took a company that’s worth $20.5 billion, and gave it $27 billion in exchange for some preferred stock. And then on top of that, we gave them valuable guarantees. Stock is nice, but if we’re handing over to Citigroup more money than the company is worth and taking additional measures on top of that to assist the company, shouldn’t existing shareholders be wiped out? Maybe that’s happening somewhere in the fine print here, but The New York Times says the government’s shares “will pay an 8 percent dividend and will slightly erode the value of shares held by investors.” That sounds like a nice gift for Prince Alwaleed bin Talal of Saudi Arabia and Abu Dhabi’s sovereign wealth fund. Not sure why it serves the interests of American citizens.

UPDATE: Krugman “A bailout was necessary — but this bailout is an outrage: a lousy deal for the taxpayers, no accountability for management, and just to make things perfect, quite possibly inadequate, so that Citi will be back for more.”

UPDATE II: Tyler Cowen: “Ugh.”

UPDATE III: See also Kevin Drum’s questions at the end.

Tough Choices

A little slice of the developing Citigroup rescue:

Regulators were debating various terms of the arrangement on Sunday, including whether the government would receive preferred stock or warrants, which are instruments that give holders the right to buy stock. Preferred stock would be more beneficial to taxpayers because Citigroup would pay dividends on those shares; warrants would be more attractive to Citigroup’s existing shareholders, since they would not immediately dilute the value of their investments as much as preferred stock.

What, exactly, is the nature of the debate?:

Regulator 1: Preferred stock would be beneficial for taxpayers, whose interests we represent.
Regulator 2: But warrants would be more favorable for existing shareholders, whose interests we don’t represent.
Regulator 3: This sure is a tough decision!

I’m confused.

UPDATE: Knowledgeable correspondents say the NYT’s summary of these issues is wrong. Warrants could be more favorable to taxpayers under certain scenarios. In particular, if coming to Citibank’s aid results in Citibank shares being much higher five years from now than they are today, then warrants would be better for taxpayers. Basically, under a warrants scenario if the rescue works really well then the taxpayer makes a lot of money.