Citigroup: The Difference Between Dramatic Action and Drama

The latest approach to the “big sick bank” (BSB) solvency crisis appears to follow this arc:

1. Convert existing preferred stock into common stock (and not just the US Government’s shares);
2. Further tighten the US Government’s managerial noose around BSB management’s necks;
3. “Stress test” bank balance sheets;
4. Inject additional capital to bring the BSBs into regulatory compliance;
5. Tighten the managerial noose even more, bowing to Congressional pressure; then
6. Pray that rising asset prices bail out both the US Government and public shareholders.

The US Government has clearly determined that its preferred stock investment has lost its “preference value,” e.g., it has a better chance of recovery by subordinating its interest and buying more time for the sick banks to become healthy. This entails placing additional regulations on how the BSBs are managed, forcing stress tests and potentially investing even more capital. This is a scary and wrong-headed way of approaching the problem.

Public Management of Private Entities: The US Government, or any government for that matter, should not be in the business of managing private entities. By imposing rules on compensation and expenses, it is mixing morality and economics in a toxic and dangerous manner. It should figure out which assets should be managed privately and which should be held and worked out publicly, and structure oversight to that end. By thus far refusing to get aggressive by either taking over the BSBs and spinning out the good assets or forcing a Good Bank/Bad Bank restructuring, public bureaucrats are confusing the notion of public and private and tossing in a big dose of moral hazard along the way. Yes, this is clearly a less shocking and dramatic step towards solving the banking crisis, but one filled with drama and poor outcomes, I’m afraid.

Stress Tests vs. Mark-to-Market: There is a big shadow lurking over the top 20 banks as they prepare for a review of their books to assess asset quality and solvency. This process, lacking both transparency and timeliness, only serves to further confuse investors, customers, and the global financial markets. What is an appropriate assumption for a further decline in housing prices? Just how high will credit card defaults go? How many counterparties will default on their CDS obligations? Stress tests are only as good as their assumptions, and with the Treasury and the Federal Reserve driving things, I’d be very concerned as to their linkage with the real world. I’ve got a great idea – why don’t they just ask for prices on all these things and stop assuming? Everything has prices. Let’s find out what they are. This is called marking-to-market. You might not like the answer but it is the market’s best guess of what something is worth, and I guarantee you it is far better than something regulators will conjure up. But just as with the large, meddling, minority shareholder approach the US Government seems to favor, forcing mark-to-market of bank balance sheets is simply too decisive, too dramatic for our regulators to stomach.

I hear that SPX futures are rallying on new of the US Government’s plan for Citigroup. My guess is that this is yet another dead-cat bounce; once investors really think about the implications, these steps create even greater uncertainty and are even more de-stabilizing than what we have today. Thanks guys.

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