Citigroup gets massive US government bailout:
Victim or culprit?

By Jon Fernquest

The global financial crisis isn't over yet.

The US government bailed out Citigroup on Monday,

What exactly did Citigroup get in the bailout?

The first time around Citigroup received $25 billion from the $700 billion set aside by the US government.

In the latest bailout, Citigroup receives another $20 billion.

The US government has also agreed to guarantee $300 billion in risky assets on Citigroup's balance sheet (backstop).


(Source: Paul Kedrosky via Economist's View).

The main complaints

The major complaint in both these bailouts seems to be that the US government (and taxpayers) are not demanding a big enough equity stake for their rescue money.

The US government is only getting an 8% return on its money when Warren Buffet got 10% for the rescue money he put into Goldman Sachs earlier this year.

The problem is, the more ownership (nationalization) the US government demands, the more they are diluting existing shareholders and thus making it more difficult for a bank to raise money on its own on capital markets.

Who is going to put money in a bank when the government could come along and take the bank and your money? This is what happened when Washington Mutual failed which may have set a dangerous precedent (Read critique of bank nationalization).

In the end, the US government may just have to take a 100% stake in many banks to clean up "toxic assets" from bank balance sheets. Nationalization is how Sweden ended up solving its banking crisis in the early 1990s (Read New York Times article).


The Citigroup bailout was the latest in a long series of bank bailouts, failures, forced sales and mergers this year:

Who done it?

The first reaction is to pin the blame on someone and look for a culprit rather than a victim.

This is the point of most articles in the New York Times "The Reckoning" series of articles (See article index).

Former Clinton treasury secretary and Citigroup director Robert Rubin is taking a lot of the blame. Along with former Fed chairman Alan Greenspan, Rubin opposed the regulation of derivatives (CDSs, CDOs) , the complex "toxic assets" that no one quite knows how to remove from bank balance sheets (See articles on shadow banking sector and CDSs).

Rubins oft-repeated motto, ominous sounding nowadays but actually just commonsense, was: "You have to take more risk if you want to earn more."

Economist Brad De Long suggests that a thorough explanation might be a more useful than blaming people. We will step through his explanation below.


The New York Times article fails to explain why "$43 billion of optimistically overvalued assets eliminate $224 billion of value."

The reasons elaborated in greater detail by Brad De Long below are:

The business of banking

As Brad De Long points out, banks are by their very nature risky businesses.

Banks are financial intermediaries that deliver the savings of households to the businesses that need these funds.

Households as savers need short-term safe and liquid assets. Banks provide bank deposits to fill this need.

Businesses as investors need long-term funds for risky purchases of capital equipment (plant, equipment, infrastructure). These purchases are risky because a business plan may not succeed. The business may fail and then fail to pay back its loans.

Banks provides long-term loans to businesses so they can purchase this capital equipment.

As financial intermediaries the business of banks is to turn short-term liabilities (deposits) into long-term assets (loans).

The fact that a bank's assets (loans) have a longer duration (maturity) than the bank's liabilities (deposits) is one source of risk for banks (maturity mismatch). If all of a bank's depositors ask for their money back at the same time (bank run) then the bank would either fail or have to be saved by a bank with even greater assets (lender of last resort).

Another source of risk for banks is that the business loans that they make are much more risky than the deposits funding these loans. The bank is required to pay back deposits whenever depositors want their money back (on demand, demand deposits). Banks may not get their loan money back if the borrower's business fails (default risk). Loan officers who work for banks develop close relationships with borrowers and during this long relationship also develop detailed knowledge about the borrower's business operations. This helps to reduce default risk. 

During a financial crisis there is typically a sharp fall in the value of the long-duration and high-risk assets that banks specialize in, so as Brad De Long says:

Comparing a pre-crisis and a post-crisis balance sheet

Brad De Long then describes how the financial crisis has affected the balance sheet of a large bank like Citigroup:

"A bank like Citigroup has a lot of assets -- a lot of people have promised to pay it a lot of money in the future. Let's collapse all those dates in the future at which people have promised to pay Citi down to one point in time four years in the future, and let's collapse all the amounts promised in the pre-crisis situation in all their different configurations down to one number: $1,263 billion. Citigroup thus has assets: in four years people will pay it $1,263 billion in cash.

"Citigroup also has liabilities in the pre-crisis situation. It has borrowed--i.e., accepted deposits (that is what a deposit is: the bank has borrowed money from you, but they call it a deposit rather than a borrowing so that you will think that what you put in the bank is still there) and issued notes to the tune of $800 billion.

"So Citigroup in this pre-crisis situation has assets of $1,263 and liabilities of $800 billion and thus is worth $463 billion right? Wrong. The $800 billion is essentially due tomorrow -- if the depositors and creditors want to get it out rather than roll it over, they can do so. The assets are in the future and are uncertain. Future assets are worth less than current assets: this is the time discount on safe assets. Risky assets are worth less than safe assets: this is the risk discount.

"With a (safe) time premium of 4% per year and a risk premium of 2% per year, Citi's assets are worth 6% less on the open market today for each year they are in the future. Compound this over four years and you get a risk factor of 0.792. In this pre-crisis situation, Citi's assets could only be sold on the open market for $1,000 if they had to be sold immediately. But you still have a healthy bank: assets with a present value of $1,000; liabilities with a present value of $800; a net worth of $200 billion.



But things can go wrong:

Post-crisis balance sheet

So now you have the post-crisis balance sheet of Citigroup:



As best as I can guess, things (1), (2), and (4) have gone wrong:

Citi's (and everybody else's, it seems) risk models were wrong: assumed that the tails of distributions were much too thin--never mind what they were doing making calculations based on tail densities about which you inevitably have no information at all anyway). This seems to have cost Citi about $30 billion in impairing the future value of its assets.

1. We have gotten bad news about housing prices, independent of the erroneous distributional assumptions in the risk models. This seems to have cost Citi another $30 billion or so in impairing the future value of its assets.

2. Has been working for Citi, not against it: the Federal Reserve has pushed short- and medium-term safe interest rates down far to diminish the magnitude of the liquidity premium--the preference for cash now rather than cash later. This would have raised the value of Citi's assets but for...

3. ...the explosion of the risk premium. The risk premium on other investment banks' assets has gone from 2% to 6% or so. Citi's premium has gone up to 8% because it right now bears the additional risk that the government will step in and nationalize it, confiscating much of the shareholders' equity stake in the process (Read ).

Should Citi's management have planned for and guarded against this explosion in the risk premium? I certainly did not expect it -- I did not think we could see this big a rise in the risk premium outside of a real cousin of the Great Depression, and I thought that modern tools of macroeconomic management would keep such a thing from happening. I never expected to see the unemployment rate hit 15% in my lifetime. I still don't.

(Source: Brad De Long at Seeking Alpha via Bronte Capital)

Posted by Jon Fernquest at 05:03 PM | Permalink | Comments (0)