Citigroup Bailout: Weak, Arbitrary, Incomprehensible

According to the Wall Street Journal, the deal is done. Here are the terms. In short: (a) the government gives Citi $20 billion in cash in exchange for $27 billion of preferred on the same terms as the first $25 billion, except that the interest rate is now 8% instead of 5%, and there is a cap on dividends of $0.01 per share per quarter; and (b) the government (Treasury, FDIC, Fed) agrees to absorb 90% of losses above $29 billion on a $306 billion slice of Citi’s assets, made up of residential and commercial mortgage-backed securities. (If triggered, some of that guarantee will be provided as a loan from the Fed.) There is also a warrant to buy up to $2.7 billion worth of common stock (I presume) at a staggeringly silly price of $10.61 per share (Citi closed at $3.77 on Friday).

The government (should have) had two goals for this bailout. First, since everyone assumes Citi is too big to fail, the bailout had to be big enough that it would settle the matter once and for all. Second, it had to define a standard set of terms that other banks could rely on and, more importantly, the market could rely on being there for other banks. This plan fails on both counts.

The arithmetic on this deal doesn’t seem to work for me (feel free to help me out). Citi has over $2 trillion in assets and several hundred billions of dollars in off-balance sheet liabilities. $20 billion is a drop in the bucket. Friedman Billings Ramsey last week estimated that Citi needed $160 billion in new capital. (I’m not sure I agree with the exact number, but that’s the ballpark.) Yes, there is a guarantee on $306 billion in assets (which will not get triggered until that $20 billion is wiped out), but that leaves another $2 trillion in other assets, many of which are not looking particularly healthy. If I’m an investor, I’m thinking that Citi is going to have to come back again for more money.

In addition, the plan is arbitrary and cannot possibly set an expectation for future deals. In particular, by saying that the government will back some of Citi’s assets but not others, it doesn’t even establish a principle that can be followed in future bailouts. In effect, the message to the market was and has been: “We will protect some (unnamed) large banks from failing, but we won’t tell you how and we’ll decide at the last minute.)” As long as that’s the message, investors will continue to worry about all U.S. banks.

The third goal should have been getting a good deal for the U.S. taxpayer, but instead Citi got the same generous terms as the original recapitalization. 8% is still less than the 10% Buffett got from Goldman; a cap on dividends is a nice touch but shouldn’t affect the value of equity any. By refusing to ask for convertible shares, the government achieved its goal of not diluting shareholders and limiting its influence over the bank. And an exercise price of $10.61 for the warrants? It is justified as the average closing price for the preceding 20 days, but basically that amounts to substituting what people really would like to believe the stock is worth for what it really is worth ($3.77).

How does this kind of thing happen? A weekend is really just not that much time to work out a deal. Maybe next time Treasury and the Fed should have a plan before going into the weekend?

Update: Bloggers start trying to be funny, world to end soon:

  • Calculated Risk (on the aborted plan to divide Citi into a “good bank” and a “bad bank”): “Hey, I thought Citi WAS the bad bank!”
  • Tyler Cowen (on the same plan, which morphed into the government’s guarantee of the “bad bank” part of Citi): “Didn’t Paulson tell us just a few days ago that TARP wasn’t needed after all? Doesn’t this mean that Paulson should speak less frequently?”

Update 2: I made a mistake in the original post: although the government is getting $27 billion “worth” of non-convertible preferred stock, it is only paying $20 billion in cash. $7 billion is being granted as the fee for the government guarantee. Thanks to Nemo for catching this. (Note to self: No posts after midnight!)

30 thoughts on “Citigroup Bailout: Weak, Arbitrary, Incomprehensible

  1. Deal is just outrageous and I agree it is not going to restore confidence. I think we will end up nationalizing all banks in near future.

  2. “Citi gets another $27 billion on the same terms as the first $25 billion, except that the interest rate is now 8% instead of 5%,”

    Not exactly. The government does get $27 billion in preferred stock, but only pays $20 billion in cash. The other $7 billion in preferred are compensation for the guarantee on the $306 billion in assets. The term sheet makes this pretty clear.

    Does not affect any of your (quite valid) points, of course.


    1) “since everyone assumes Citi is too big to fail, the bailout had to be big enough that it would settle the matter once and for all.”

    Why? If nobody knows for sure how much will be needed, why should the government invest huge sums of money into Citi that might not be needed? Why not do it incrementally?

    The message has been sent: We will not let Citi and similar banks fail. Who cares if a handful of people nine months from now have to spend another weekend preparing another capital injection into Citi? You know they will do it if they have to.

    Isn’t it possible they looked at all the on and off balance sheet assets and liabilities of Citi and came up with their best conservative estimate as to what Citi could potentially lose over the next year or two? For Pete’s sake, give them a break.

    2) “it had to define a standard set of terms that other banks could rely on and, more importantly, the market could rely on being there for other banks.”

    Is this possible? Isn’t every situation different? Doesn’t BAC have different amounts of troubled assets than Citi or GS or MS? Shouldn’t the money invested depend on how much potential trouble the company is in? Just what exactly should be standardized? You have to give the people who implement these deals a little bit of leeway to tailor the solutions to the individual banks.

    I don’t understand this post.

    Tom Krebsbach

  4. At the current capitalization, why not just purchase the damned thing outright? It would be cheaper, considering that either way the taxpayer is assuming Citi’s liabilities (assuming that the partial guarantee announced this weekend is the first tranche of a carte blanche commitment). Not that I favor either course, however.

  5. I must admit that I’m pretty confused. If you assume that Citi is really going to have at least $160B in bad securities, how is $7B reasonable compensation for assuming the $160 – $27 billion, or $133 billion in liabilities that will appear after Citi burns through the initial $27B?

    Isn’t this just an amazingly generous deal for Citi?

  6. Tom K: That’s a valid argument. It depends on what you define as the problem. Through Friday, Citi was just the leading edge of a wave of troubled banks. CDS spreads were rising on everyone, not just Citi. I think the underlying problem is that although everyone assumes that the big banks will continue functioning, there is a lot of uncertainty about how that will happen. We’ve seen Bear Stearns, Lehman/AIG, TARP I, TARP II, and now TARP III. In particular, the only explanation for CDS spreads as high as they were is that investors think that Treasury might “pull an AIG” and do a bailout that hurts creditors, not just shareholders. As long as that risk exists, people will be nervous about lending to banks.

    Now, the Citi bailout did not hurt creditors. But it also didn’t establish guidelines or principles for future bailouts, so the markets will have every reason to worry all over again in a few months. Having a bank panic every 2-3 months is not a good recipe for recovery.

    Now, I think we can legitimately disagree over whether it would have been possible to establish principles that the market can rely on, especially with a change of administration looming. I think it is not implausible that Treasury could have said: (a) we are requesting the other $350 billion; (b) we are allocating all (or a lot) of it to save these X named banks; (c) the money will always be available on these Y terms; and (d) Citi is the first bank to take the money. Or something like that – my point is not about the specific terms of the plan, than the benefits of having such a plan. If the idea is for the government to provide a backstop for troubled assets, it could have established a calculation for how to value those assets, a new agency to own and manage those assets, and rules governing how that agency will operate, including how and when it will unload the assets. Obviously this is more than you can work out over one weekend, but they can’t say they didn’t see this coming.

    If I’m right, this would have the benefit of giving the market visibility into the likely future of these banks. Now, it’s possible that whatever the government did this time, the market would assume that it can be torn up in the future. That’s the problem when you’ve already made a number of policy changes. But I think the bottom line this morning is that the government bailed out Citi, on terms that are relatively favorable to the shareholders, in a way that does not guarantee Citi’s long-term health, and leaves everyone wondering what will happen the next time a bank shows up at the door. Maybe that’s the best that could have been achieved.

  7. PghMike: Two things. First, the guarantee is only for a $306 billion pool of assets. These are presumably the worst assets, so they may lose a lot, but the losses on these assets will not necessarily be all of Citi’s losses. The bet is that $7 billion in preferred stock is fair compensation for a guarantee that only kicks in if the pool loses $29 billion (about 9.5%).

    Second, the FBR report I cited says that Citi needs $160 billion in capital in order to be adequately capitalized – not that they will have $160 billion in losses. It doesn’t forecast Citi’s specific losses, but if Citi performs as well as the average of their sample I get about $60-70 billion in losses.

    Still, I’d say it looks like a good deal for Citi and its shareholders. Not criminally good – it’s worse for shareholders than the first $25 billion injection – but good.

  8. How about this:

    – Paulson’s original TARP plan to build a market for bad assets was dropped when it became apparent that, if a market was created, the prices would be so low as to immediately bankrupt virtually every major financial house on the planet.

    – Paulson wasn’t quite ready for that, so he instead used (and continues to use) TARP to build a curtain around the banks to hide their nakedness. Citi is just the latest curtain.

    – of course, in parallel with the bank problems, we now have credit-driven or at least credit-exacerbated business failures (i.e.; housing, GM/Chrysler/Ford, many others to follow), which of course worsen the pressure on the banks as both consumer and business defaults will inevitably rise. That’s why Congress has to “save” the automakers — at least for a little while — and pump LOTS of money into the system to force inflation and effectively void some percentage of the outstanding debt.

    – the long-term (12-18 months?) goal is not to preserve all of the banks or to save all of the automakers or to make everyone whole again — it’s to provide some modicum of stability so that the nightmare can wind down in as orderly a process as possible. Citi, GM, lots of others will ultimately be toast. But they can’t all be toast at once…

    There has to be something left to build from — that’s the goal. If everything gets destroyed and has to be re-built from scratch (which could still happen), then we’re looking at another 20-year bust.

  9. There was a relevant conversation on Sunday’s CNN GPS between Fareed Zakaria and Niall Ferguson:
    “ZAKARIA: So, what do we do, Niall? Because you’re right. The bank bailout hasn’t worked. They’ve used $350 billion. It seems as though it just isn’t enough capital.

    “FERGUSON: I think it’s not been enough, because the losses are still much bigger than anybody’s acknowledged. If you figure out how much has been lost — the Bank of England came up with a ballpark figure for the global financial system of $2.8 trillion. Well, the write-downs that have been acknowledged so far are a fraction of that.

    “So, part of the problem is the banks don’t trust one another, because they know that there are many more bodies buried out there than have yet been exhumed.”

    If part of the problem is bank trust, then the core of that problem is lack of transparency. As Neil Rackham puts it “the deeper you see, the more you trust”. Conversely, the less you see, the less you trust.

    Here we go again with “Project Chicken”: nobody owning up about their problem in the hope it will soon be dwarfed by someone else’s much bigger one.

    You cannot make people come clean about problems. Attempts to do so generate denial and hostility. Direct challenges will most likely trigger defences and result in greater obfuscation. No force or ultimatum or major argument is going to work.

    All you can do is create an environment where it is safe to talk by listening, by being someone who can be trusted to listen. People have to come to the decision that it is a mistake to continue to cover up problems. Few people can do that in an environment where others insist they were wrong to do so in the first place. Our first instinct is to protect ourselves. We need a place to go that is secure.

    Messengers, traditionally, get shot. So when people start having doubts about keeping silent, provide an alternative. When they call and want to talk don’t be surprised, be supportive. Find out if they feel threatened. Get them to talk about it. What effect is it having on them? Does it make sense? Don’t use their confusion to flood them with information. You can ask them about the specifics, but realize that they have a lot to think about. It can take some time. Give them space. Let them ask for information or find out themselves.

    It is inner conflict that overcomes conspiracies of silence. If people want to talk, get them talking. Have them describe their experiences, good and bad. Talk helps if the listener is non-judgmental. These kinds of discussions – getting people to think about what they have experienced and observed as compared to what they have been taught and led to believe – are the key to breaking the spell they are under.

    This is all very well on a one-on-one basis but how do you create an environment that is safe to talk on a grand scale? Well, that’s what my web-based groupware, a Yala, is about.

  10. This may have came up somewhere, but if Citigroup is in such a need of bail out, why is it buying other banks? You know it bought Watchovia last month but you may not know that it is buying banks out of country. It bought a bank in Costa Rica earlier this month and there may be more.

    It seems that they are really abusing the system and make their finances look bad to US while outside of US they are buying others.

  11. It is clear that rumors and artificial panics are being created and propagated by greedy short sellers. The solution has to respond to this problem. That means, the government must make these short sellers lose some big bucks. Hit them where it hurts!

    How do we do that? Let’s take Citi as an example. Put a tender out there to purchase X amount of Citi shares at $20 a share. This will put a real short squeze and clean many of the greedy short sellers. They will think twice from shorting and creating false rumors in the future. And we will have more orderly market.

    BTW, I don’t own Citi shares.

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