Slouching towards nationalisation

November 26, 2008

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

The Citigroup bailout is sure to succeed, but only if you count avoiding making unpleasant but needed decisions as success.

It won’t work if you define success as building confidence and attracting private capital back to the banking system. It fails to work out a clearing price for rotten assets, and though it underwrites $306 billion of them even this huge sum is not enough to suspend disbelief.

It won’t even work if you define success as jump starting Citibank lending to private borrowers. The bankers have every reason to keep their heads down and pray they can slowly rebuild capital rather than lending into the biggest downturn in two or three generations.

At best it buys Citibank some time, though heaven knows what they can do in the next little while to stave off a cascade of writedowns in their housing and consumer loan books, much less their emerging market businesses.

It also, and I think tellingly, avoids taking a credible decision on whether Citigroup, and by extension the U.S. banking industry, can avoid explicit as well as effective nationalization.

We are in a really dangerous moment when is it apparent not only that no one really knows what to do, but that the people making decisions now are not the ones who will be left to sort them out once a new administration takes power in Washington. That provides a ready excuse to simply kick Citigroup’s can along the road.

One thing is very clear; the terms extended to Citigroup were a lot less difficult to bear than other earlier bailouts. I would guess that this is because the government is terrified that they have become the only game in town. The government is in a double bind; they must extend capital to banks or see them fail but every time they do it they make the banks less attractive to private money.

Any more radical solution would be difficult for a lame duck administration to attempt, and given the size of the banks involved, very daunting.

The United States will invest $20 billion in Citi preferred shares which will pay an 8 percent dividend. The government will get 10-year warrants to buy $2.7 billion of common stock at $10.61 per share, as against Citi’s $3.77 price just before the deal was announced.

The government will guarantee $306 billion of Citi assets, with Citi taking the first $29 billion in pre-tax losses and the government on the hook for 90 percent of the losses after that. These assets will remain on Citi’s balance sheet and it will continue to get any income they generate but Citi will issue $7 billion of preferred stock, which will also pay 8 percent, as a fee. These assets will only be 20 percent risk weighted, which will free up an estimated $16 billion of capital. All in all, it was enough to underwrite a more than 70 percent rally in Citigroup shares.

Crucially, we’ve not yet seen any indication that we will get a full accounting of exactly how that $306 billion was valued, other than it was agreed between Citi and the United States. It is another example of the U.S. saying: “Don’t worry, we will make it all OK,” without exactly specifying what “it” is.


And of course without being able to see what the assets will actually fetch, especially in a declining economic environment, who would want to buy the pig in the bank’s poke?

That being the case, and in the firm expectation that loan losses will mount as the economy worsens, it’s a fair bet that the vicious cycle of writedowns and capital need will continue. In the absence of some real clearing mechanism for banking assets, and a willingness for government to pick up the pieces for those banks that can’t survive, expect more requests for life support from more banks.
But governments are finding it increasingly frustrating, at least publicly, that they pour money into banks yet see little in the way of lending come out the other end.

“The heart of the fear for all of us that still value free markets is that governments will eventually decide to nationalize whole swathes of the global banking system to ensure that the money they’ve invested in the recapitalization trade filters through into the wider economy,” Deutsche Bank credit strategist Jim Reid wrote in a note to clients.

“Ironically there may be a time when banks have to decide whether they need to make loans that may prove to be loss-making just to avoid governments losing patience and nationalising them.”

It is really a worst of all worlds, a circle of cynicism; governments prop up the good and the bad in the banking system, which in turn makes loans it doesn’t really think make any sense.
It’s a heck of a way to allocate capital, and almost as bad as the old system.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —

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