Friday, November 21, 2008

Sheila Bair and seizing Citigroup

I suggested that Sheila Bair might seize Citigroup precisely because it is the sort of irrational, arrogant and dumb thing she does.  She did after all force the issue at Wachovia – signing a government guarantee (to Citigroup) even though a fully private sector solution was available.

But people took my suggestion seriously.  Some thought I had “jumped the shark”.  Others thought that I was straight predicting it.

So now – just to lay out the issues – I am going to discuss – in all seriousness – what a government seizure of Citigroup would look like – and how it might affect the rest of the economy and other bank stocks.

It is open to Sheila Bair (and her fellow regulators) to seize Citigroup (deeming it unsound) and to leave at the holding company – and worth near zero – all the equity, preferred shares and holding company debt obligations.  Indeed this is precisely what she did at Washington Mutual.  What she did once she might do again. 

This will in fact result in a full successful resolution of the Citigroup problem at no cost to the government from Citigroup.  There is a darn strong case for doing it. 

Here is the liability side of the Bank Holding Company balance sheet from the last filing period:

 

 

I am sorry it is in thousands but it is a regulatory statement – and that is how they come. 

Click and look at it.  There are 17.5 billion in short term parent company debt and 117.5 billion in parent company debt with more than a year’s maturity.  There are a further 27.4 billion in perpetual preferred securities and 28.5 billion in subordinated debentures. 

If Sheila Bair confiscates Citigroup and leaves all those liabilities at the holding company then it is economically the equivalent of a 184 billion dollar equity injection into the remaining group.  A cancelled liability of course is the equivalent of new (non cash) capital.

The new Citigroup should be adequately capitalised – albeit government owned.  The FDIC could IPO the new Citigroup once this market mess had died down (and remit most the proceeds to former bond holders).  A shrinking Citigroup with an additional 184 billion in capital shouldn’t cost the government anything.

But Sheila Bair does not need to stop there.  She has the power to guarantee some assets of the new entity – and her guarantees carry the full faith and credit of the US Government.  She did this with Wachovia.  The new Citigroup could then put the guaranteed assets into a special purpose entity and repo finance the entity.  This would look similar to repo-financing treasuries – and the new Citigroup could thus obtain very cheap funding.  That cheap funding would guarantee its liquidity and its profitability – and hence ensure that the government does not lose anything further (other than borrowing capacity) from the Citigroup nationalisation.

Remember both steps of this Sheila Bair has performed before.  She confiscated Washington Mutual and left behind the parent company liabilities.  She guaranteed assets at Wachovia.  This is Sheila Bair’s proven style.  And she would look a hero because Citigroup would be resolved at no cost to taxpayers.

But…

And you knew there would be a but…

If Sheila Bair was to confiscate a really big bank and cancel all the parent company liabilities then no other bank in America would be able to raise parent company debt.  Indeed I think that has been the case ever since Sheila Bair did the reckless and irresponsible takeover of Washington Mutual… but it would certainly be the case if the parent company liabilities of Citigroup were cancelled.

And that would be a huge decision indeed because then every bank with parent company liabilities (meaning almost every bank in North America) would fail. 

Many – but not all – could be taken over in the same fashion at little cost to the government.  But almost all of them would wind up property of the US Government.

Full nationalisation, Swedish or Norwegian style, is an effective end to a financial crisis – and Sheila Bair has the power and has proved that she is willing to use it.  But it is a decision way above her pay grade.  (Where is President Obama’s new Treasury Secretary?)

My view is that Sheila Bair should not only not use the powers she has previously shown a willingness to use – but that she should resign immediately and admit that her previous decisions were in error.  She should resign now – or Citigroup is likely to be hers anyway.  

 

 

John Hempton

Postscript:  The Holding Company has several regulated subsidiaries - presumably in several jurisdictions.  All the regulated subsidiaries would have to be seized together - and if some came up short some form of solution would need to be found.

Postscript 2:  Actually I think the die was cast for Citigroup when Sheila Bair confiscated WaMu.  The lesson was learnt that bank debt could be treated very unfairly by regulators and hence banks were never going to be able to get finance again.  The worst decision of this cycle was to let Lehman fail so badly - creditors got very scared.  The second worst was the reckless way in which creditors of WaMu were treated - it made them even more scared.

14 comments:

Hubert said...

John,

how much probability do you give this scenario? What about the CDS issues around it? How would the financial world look in the aftermath?
I cannot believe they do it this way - but what are the alternatives? Government buying Citi for 2 cents a share?

Richard Smith said...

I agree that SB's takeover of WaMu made it crystal clear to private investors that putting new capital into banks involved a whole new level of political risk. But I wonder whether she was just recognising the inevitable. Look at the fate of the private capital raised during H1 08 by the likes of Citi, Merrill, Lehman, UBS...all pretty much gone - because it wasn't even close to enough. I don't think there was much capital raising in Q3 08 and I think that's because investors already knew that they weren't getting an accurate prospectus - and had seen early entrants get completely hosed. All of this NB before the admittedly reckless and clueless decsion to let Lehman go under. Of course the emergence of a $100bn hole on Lehman's balance sheet post bankruptcy did rather confirm the suspicion that banks weren't telling the whole truth about their finances - but that would have come out anyway over time if they had been taken over or nationalised. Would an informed investor have put $100Bn into Lehman? I don't think there were any possible returns that would have justified doing so. Same may go for Citi and some others and I think propective investors suspected this long before September.

The end game - lots of bust banks, including needlessly bust banks - has been foreseeable since this time last year (and longer). During that time, little was done to facilitate any triage of banks. And now we're out of time, so it will get very messy.

John Hempton said...

Hubert asked me about probability that it would happen this way.

I do not know. Really do not know.

The decision to confiscate Washington Mutual - which had single digit delinquency and could have stood 20 billion of losses over a couple of years and remained adequately capitalised was bizarre.

I thought Sheila Bair should have resigned then. I thought it again when she was caught making bizarre choices on Wachovia.

I think she should resign now.

But she has proven that this is the way she acts.

Surely she recognizes that Citigroup is a decision above her pay grade.

J

# 56 said...

She is making a grab at TARP assets for a new foreclosure avoidance program. Get used to her, Obama is digging her act. Like Gates she looms as a holdover.

Anonymous said...

The decision to confiscate WM was made when the initial bailout vote did not have support. What better way to generate support for a bailout then to scare people? And what better way to scare people then with a major bank failure? Wamu was close, it got kicked for political reasons. It didn't matter because the vote still failed (1st time)

Anonymous said...

Would Capital Trust Preferreds invested in Jr Sub Debt be wiped out the same as Holdco Preferred that is parri-passu with TARP Preferred investment? TARP level Pfd trading 900bps wide of Capital Trust right now.

Anonymous said...

And that would be a huge decision indeed because then every bank with parent company liabilities (meaning almost every bank in North America) would fail.

You mention "North America" here, implying that this includes Canada. Are you saying that Canadian banks would fail too as a result of a US FDIC decision, or merely that Canadian banks also have parent company liabilities?

And how would the chain of events play out to bring about this failure? Universal runs on banks, or what mechanism exactly? It's a startling claim, I hope you can clarify.

Eidolon said...

Amen! As a bondholder of WM and substantially more so of C, I have been aghast at the raucous developments Bair's REALLY very bad choices have instigated. I frankly can't believe she's still with us! We will see where C goes very soon.

I'm curious to know your take on the likelihood of a reversal of any of the WM fiasco (by the judiciary or otherwise as a result of bankruptcy proceedings?). Surely Bair is not completely immune to official reproach. I know I'm not alone in holding a bunch of tanked WMQ shares out of curiosity.

MJD said...

This will likely strike you as stupid, but I'm not an economist, and I just need some peace of mind...

You say full nationalization is a way to end the crisis. But if that is what it comes to; wouldn't that leave the holders outside the US hanging? I mean, not only can banks not raise cash through their parent companies, but whoever hold that debt will find themselves having to write down an insane amount of assets. If that stays inside the US, whatever firms going under on Citimom's CDS will likely get a government bailout themselves (if deemed sufficiently important). If it's global, they will, but only if their governments can. If that was indeed what we did up here in Norway 15 years ago, the world goes on because we're a small and insignificant economy. Obviously not so with the US, and moreover, I would imagine this hits asymetrically. Or at least that is what markets would suspect.

Now, here's what has me worried: I refuse to believe that if Citi is standing on the edge, they are alone. If Citi goes, so does a bunch of other places that may or may not otherwise have done so. And not all of those CAN get a bailout, no matter how much they need it. You yourself have pointed out that several nations simply cannot afford it. And up goes the IBOR's again, only this time for longer and harder than in October. "Once is a trick, twice is a lesson." And I can imagine a lot of things the economy would want now before another credit freeze.

So to me, Citi going down, bailout or not, sounds more or less like armageddon. And if it is going, by now it might not even be anything anyone can do other than try to be ready to clean up the mess. So why am I wrong? ('cause I AM wrong, right?)

MJD

CouldMarxBeRight said...

After hearing your proposed bailout approach (effectively the WAMU approach of wiping out holdco bondholders) I went sound asleep thinking that there is a way for the US government to prevent a Lehman-style collapse of Citigroup.

But then I woke up in terror to the following questions I have:
The WAMU seizure and subsequent sale to JPM went swimmingly because WAMU wasn't a primary dealer. If Citigroup was seized by FDIC and Holdco bondholders wiped out, wouldn't that trigger cross default of most of Citi's derivatives contracts outstanding? As a primary dealer the repercussion to the financial system would be the same as if Citi files for bankruptcy. I believe it is the same reason why the government had to keep plugging the bottomless hole of AIG and making its bondholders whole. The only problem is while AIG was a $1 trillion balance sheet, Citi is a $3 trillion balance sheet or more. And Citi is probably several hundreds BILLIONS dollars in the hole when all is said and done.

Paul W said...

Citi is much more politically connected. I opine that the issue would have to be forced.

CouldMarxBeRight said...

John,

I've always found your blog very rewarding to follow and thank you for sharing so many insights.

I also would like to share what I coin "a tale of two continents" with you, which has been a way I summarize what's been going on in our financial system. I'm sure you can plug in better figures and modify it to reflect the reality better. But I hope to capture some salient aspects at least.

There was two economy with about $120BN of bank equity and using the old banking paradigm, there could be $10 trillion of loans extended in this economy. Now we start pooling this $10 trillions loans and slice and dice it. Get the rating agencies to put AAA ratings on these securitized and repackaged loans, we suddenly find that the risk-weighted assets shrink dramatically, thus allowing the banking system to lever up more. Instead of $10 trillion loans, we suddenly find that our "new banking paradigm" easily allows $30 trillion of lending. Leverage might have go up from 12x to $36x. But hey, the regulatory framework said it was ok.

In US, this happened mostly through the shadow banking system and especially at the broker-dealers and money center banks such as Citigroup.
In Europe, this happened directly at banks such as DB, UBS, Soc Gen, Barclays, RBS, HBOS, etc.

Maybe you can pick out one bank and say, "Hey their total leverage may look high at 36x, but those are assets with way-below-average risks. Their book may be less risky than a 12x leverage commercial bank book". Sure that's possible. But will you see the problem when EVERY BANK has raised leverage significantly in the past 10 years? One bank or another may have a book that's below average in risk. But not every bank can be below average in risk. It's like saying that every fund manager is above average in their returns. When the aggregate total leverage of the financial system went from 12x to 36x, then the system is overlevered. It has to unwind and go back to historical norm, if not overshooting it.

Simply put, there is just not a way for those 30x leveraged banks to unwind back to 15x without A LOT OF PAIN. Citigroup had a whole year to do it but they botched the job, mostly because it was mission impossible to begin with.

Don said...

I'm not sure I understand your view of Bair. Here's my understanding of how things went:

Saturday, October 4, 2008
Not Really Free Market After All
Paulson's stimulus plan:

"Treasury Secretary Henry Paulson’s plan, which is now law, is fiscal stimulus that will be injected directly into the banking system to supplement almost nonexistent private-sector lending with government cash and determination. Mr. Paulson may be shooting the right weapon at the right time because it will help rescue the banks while restarting corporate and consumer lending.

But Mr. Paulson’s fiscal-stimulus work didn’t end with the bailout bill.

With hardly anyone noticing, on Wednesday he pushed through very technical and obscure changes to tax regulations that provide a “tax subsidy” for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson’s tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the “free markets work without government help” don’t understand the motivating effect of several billion dollars of tax benefits to Wells Fargo."
Your government's dollars at work.

And this post:

Saturday, October 4, 2008
Are Regulators Always Wise?
On the Wachovia sale:

"Lawyers not involved in the battle said that Wachovia could defend the Wells Fargo deal by arguing that it is better for its shareholders. Wachovia is likely to claim that its fiduciary obligations — its responsibility to protect the interests of its investors — required it to consider the Wells Fargo bid and, given its higher price, to accept that bid.

The litigation could put regulators in a difficult spot. The Wells Fargo deal may be better for taxpayers, but if it succeeds, in the future other financial institutions may not be willing to help the government, as Citigroup did, because of the risk that they might not reap the anticipated benefit."
You think?

In others words, what happened was:

1) The FDIC brokered a deal between Citigroup and Wachovia
2) TARP included tax subsidies benefiting acquisitions
3) Wells Frago made a better offer for Wachovia based on those tax subsidies in TARP
4) Pitting the FDIC against the Treasury Plan
5) Citigroup sued, feeling that this was unfair

It seems to me that both sides had a point:
Citigroup had been solicited by the government to do this first
Wells Fargo gave a better deal to the taxpayers

What am I missing?

Don the libertarian Democrat

Anonymous said...

John, investors in bank corporate debt should always realize they are subordinated to depositors.

That said, your conclusion that Bair's WM seizure and stubborness on C/WB/WFC will make it impossible for banks to issue debt is probably correct but incomplete. They'll raise tons of debt now that the FDIC has finalized its guarantee rules. And the biggest beneficiaries will be the same as those who benefited from the Paulson plan: the corporate bondholders of big banks.

See a great U of Chicago paper called "Paulson's Gift."
http://www.chicagogsb.edu/email/chicago_on/PaulsonsGift.pdf

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