Playing Chicken with Citigroup (C)

What does “too big to fail” mean anymore? Bailing out equity-holders? Debt-holders? Depositors? Entrenched managements? Sovereign wealth funds and other large offshore investors? We need to define our terms and our goals and we need to get it right. And one of the most stunning case studies for what this means in a post-AIG bailout world may well be Citigroup.

Citigroup (C) touches every part of the U.S. economy and many parts of foreign economies as well. An out-and-out failure of Citigroup would invariably cause ripple effects across the global financial landscape due to its labyrinthine counterparty risks, collateral held on behalf of others, worldwide branch network and panicked depositors. Rightly or wrongly, I assign a zero probability to Citigroup being forced to file Chapter 11, so then the question becomes: what does happen if it hits the wall a la Bear Stearns or Lehman Brothers?

Option 1: TARP-style bail-out

This would involve writing $25 billion checks on a quarterly basis for the foreseeable future.  There would be no end in sight since the amount of toxic waste residing on Citigroup’s balance sheet (see Assets, Level 3) is in the tens of billions and currently unknown. Transparency is not yet at hand. This plan would protect equity-holders and debt-holders at the expense of the U.S. taxpayer and better-run competitors. It would also protect the investments of sovereign wealth funds and Prince al Waleed, two constituencies who would likely go ballistic if Citigroup’s stock price went to zero. The political ramifications of such a move shouldn’t be underestimated, yet the impact of irritating offshore investors now pales in comparison to best dealing with the global financial crisis. Sure, they hold a lot of U.S. Government debt, but right now that is perceived as the safest paper in town. That said, this plan reeks of moral hazard and burns the very people who have the most skin in the game: the average U.S. citizen.

Option 2: Good Bank/Bad Bank restructuring

This would entail a multi-step process that wipes out common stockholders, and potentially some preferred stockholders and debt holders as well:

1. Separate Citigroup’s Level 3 and other illiquid financial assets (“Bad Assets”) from the others (“Good Assets”) ;
2. Sell the Bad Assets to a Treasury-controlled special-purpose vehicle (“SPV”) at market value. The SPV would be owned by the U.S. taxpayers;
3. After receiving the cash proceeds of the sale, take the book loss and mark down the capital account. Use free cash to pay off creditors beginning at the top of the capital structure. Some creditors will be paid and other’s won’t. That is part and parcel of the risks of investing; and
4. Compute the amount of capital necessary to bring the Good Assets – now the Good Bank – into regulatory compliance under the BIS standards. Capital can be provided by either public or private sources. The Good Bank, now freed from balance sheet uncertainty and with an attractive global asset base, may be an appealing candidate for private equity investment. If not, the U.S. taxpayer – through the U.S Treasury – will make the necessary capital injection. It will get a good deal.

This solution avoids moral hazard, penalizes those who took risk with the hope of great reward, and provides the U.S. taxpayer with a fighting chance to earn a fair return on its investment. Further, the Good Bank will not be motivated to hoard capital, since its clean and transparent book will be adequately capitalized and without the embedded mega-disasters causing most banks on the planet to apply for TARP funds. Will common and preferred equity holders be irked? Yes. Big deal. They are at the bottom of the capital structure for a reason: trying to capture the benefits of a levered return. Sometimes leverage works against you, as it has across many large financial firms. And in those cases, you lose. This is one of those times.

Conclusion

The time has come to drop the arguments over mark-to-market accounting, FAS 157 and fairness. If you can’t finance your book, you are dead. Period. This isn’t about accounting; it’s about survival. This is a plan U.S. citizens, Congress and global financial leaders should be able to get behind. And they should apply the same solution to their problems. Because once we have financial firms with transparent, clean, well-capitalized balance sheets, the motive to stockpile capital is gone. Then we can turn our attention to the real economy where things are just beginning to get bad. But one step at a time; we need to lay the foundation for capital formation as the real economy starts to heal, and it all begins with a healthy banking system.

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