During the Lehman failure, the Federal Reserve and other agencies put quite a lot of effort into making sure that the ripple effects didn't spread too far in the markets where Lehman was a major counterparty. They were successful: the unwinding of Lehman's positions has actually been rather smooth, though slow and not particularly happy for the counterparties. What they hadn't known, and indeed, couldn't really have known, was that the effect on Lehman debt would cause the value of a smallish money market fund aimed at institutional investors would break the buck. And because breaking the buck is so rare--the last major one had occurred in 1994--they certainly didn't see what would happen next, which is that the commercial paper market would completely freeze up, threatening massive effects in the real economy, like firms not being able to make payrolls.
What hidden issues like this lurk in a Citigroup bankruptcy? Compared to Citigroup, Lehman was a simple entity; it borrowed some money, it issued some securities, it bought and sold some other securities. Citigroup is a bank, a trading operation, an insurer . . . and it has commercial banking operations in something like 119 countries, all of whom have their own opinion about what should happen to the company, and regulatory authority over at least a piece of it. It's tempting to think that the Lehman bankruptcy has already exposed the potential problems from any collapse
Then there are the effects we can predict. If we really let Citigroup go bust--wipe out everyone except the depositors up to the FDIC insured limit--there are some fairly predictible effects. Being an economics writer, and therefore prizing gains from trade, I will outsource my explanation to another blog:
Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can't.
For the last six months, where has that confidence been coming from? Not from the banks' balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.
The story goes something like this. Let's say that Citigroup were restructured - via bankruptcy, or via government conservatorship - in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.
The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again. Or almost: it is possible that the Federal Reserve's massive efforts to provide liquidity to the banking system will be enough to keep banks functioning. But who wants to take that risk?
This is why, for the last five months, the government has been doing everything it can to imply that bank creditors (at least for "systemically important" banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.
Would the cost of letting the bank fail exceed the cost of bailing
them out? Impossible to say. But the cost of implying you won't let
the bank fail is definitely smaller than either actually bailing it
out, or letting it go to the devil. Geithner et al. are hoping that
the implication will be enough to make the actual act unnecessary.
I'm pretty sure that by definition a second order concern cannot be bigger than a first order one.
One thing I don't understand is how FDIC insurance interacts with the waterfall that is the capital structure of the bank.
As I understand it, bank deposits are junior, unsecured debt, but also insured. My expectation is that the senior and secured debt would be largely made whole by a Citibank failure, while the junior and unsecured debt would take a huge hit. However, since the money goes to those at the top of the capital structure first, the FDIC could end up paying out the entire value of the insured US Citibank deposits because all the assets were used to support more senior debt. That is, as long as the bank's assets are sufficient to pay off the senior stuff, since the FDIC is covering most of the junior stuff, won't it be the taxpayers and not the bondholders that foot the bill? That would be a serious transfer of wealth from the US taxpayer to the Citibank depositor and creditor.
"This is why, for the last five months, the government has been doing everything...": Obushma.
"Obushma". I like that, dearieme. I intend to steal it whenever applicable.
OneEyedMan,
It's complex, and has to do with the relationship between Citibank and Citigroup. Citibank would be taken over entirely by the FDIC, with assets being used first to pay depositors under $250,000, then depositors above 250, and only then to pay off other creditors. The remainder of Citigroup however would be dissolved in bankruptcy and would go entirely to paying creditors.
This is somewhat speculative because the US has never taken over a bank holding corp this complex, and there might be some special plan which would be used, making what I said above wrong.
"They were successful: the unwinding of Lehman's positions has actually been rather smooth, though slow and not particularly happy for the counterparties. "
Huh? Did you forget about AIG? They were the guarantors of Lehman's CDOs. That's why the fall of Lehman was quickly followed by the takeover/bailout/whatever of AIG.
The lesson learned (by Paulson) was that "just letting them fail" is nice in principle, but ...
Norman is correct- AIG was taken over the same day Lehman failed. The two were connected at the hip, thigh, and shoulder.
This is somewhat speculative because the US has never taken over a bank holding corp this complex, and there might be some special plan which would be used, making what I said above wrong.
Sometimes regulators have to try new things. Even if the first attempt doesn't turn out well, they can learn from their mistakes to improve subsequent attempts. That's what happened with the Resolution Trust Corporation back in the S&L days if what I've read is true. All things considered, the S&L crises turned out okay.
Now we just need our fearless leader to admit (at least to himself) that the banks are insolvent and give the FDIC the resources it needs to take the banks down in an orderly manner without screwing the taxpayer too much.
Nelson, Citi is nearly sui generis. Saying that regulators will do better next time isn't comforting. The 3 or 4 banks that folks are most worried about are significantly different from the S&Ls, in size and scope and importance to the financial system. And as I understand it the FDIC doesn't have authority over all of Citi's operations.
Peter, I believe you are incorrect.
I'm pretty sure that secured debt holders of the bank are paid off by the assets of the bank before the depositors are.
I'm having trouble finding anything online by the FDIC to say either way, but from what I know about how they treat off balance sheet transactions, covered bonds, and netted derivatives, I don't think that the depositors get paid off first as a general matter.
I'd love to know more if anyone has any good references.
Citi could be a trial run for how they handle BoA.
And as I understand it the FDIC doesn't have authority over all of Citi's operations.
This isn't a problem. Gaining authority is easy if the alternative to the stakeholders is losing everything.
"AIG was taken over the same day Lehman failed"
Yes, but would AIG have been just fine if Lehman had been 'rescued'?
Ann,
I don't know, but if Lehman had been "saved", a lot of the counterparties to AIG would not have been filing claims with AIG at that time.
Don't misunderstand me, I am in no way meaning that Lehman should have been rescued, but I do think the government was attempting to ameliorate the damage of Lehman's failure by backstopping AIG's liabilities in regards to that failure.
Yancey -
Thanks for the answer. I'm certainly not claiming to know what would have worked best.
The Treasury of the United States is more important than every bank in existence. This is my marker. My line in the sand.
Moving the various giant banks into bankrupts, where they belong as a simple matter of fact, presents a terrible dilemma for citizens and policy makers. On the one hand letting them go guarantee more pain in all asset markets. Propping and bailing is destroying the US Treasury.
There is terrible angst and confusion on the bank-financial institution bailouts on the right because they present complex ideological dilemmas and further dilemmas that are not ideological so much as just ones related to their prejudices. All over and above the simple dilemma.
In principal every conservative worthy of the title should support the bankruptcy of the bankrupt banks. (again there is no reason to pretend C is whole. Their gigantic store of crappy unpriceable Level 3 assets is a matter of accounting forbearance which is a lousy figleaf trying to cover their actual bankruptcy) However every conservative who has assets wants to keep them and keep them from falling. Thus they hate that the Treasury is promising to back up crummy crumbling asset prices on principal, and yet hope it works.
There is a very deep issue with the Treasury here as well. If the Treasury was ruined. Could no longer borrow the money necessary to pay all its bills then finally the welfare state could be killed. I know nobody believes this possible. However it is possible but I can't say how probable. The thing is at some level most conservatives in some dark daydreams must be thinking of the possibility.
What would a United States look like after the bankruptcy of the Treasury? Why National Socialism of course.
A "simple" run on the bank instead of on its stocks would tel us the truth. It's the only solution...
OneEyedMan/Peter:
Order of priority is secured creditors to the extent of their security (including secured loans and derivative collateral), expenses of the receiver, ALL depositors, general/senior creditors, subordinated creditors, and shareholders.
In a deposit payoff, the FDIC pays off insured depositors out of the Deposit Insurance Fund, and the insured depositors subrogate their claims against the bank to the FDIC. The FDIC then has a claim as subrogee that ranks pari passu with all depositor claims. The FDIC therefore shares in depositor losses pro rata with uninsured depositors.
Usually, the only shareholder of a bank (e.g. Citibank) is its holding company (e.g. Citigroup), so all holding company creditors are structurally subordinated to all claims against the bank.
Aw, c'mon. I want to know what, if anything, "break the buck" means. Or if that sentence can be saved.
You've had eight hours to fix the link & sentence. Get to work already.
Is there no moral obligation?
What happens WHEN Citi fails:
1. FDIC is forced to jack up the insurance premiums of all other banks to remain solvent, therefor significantly increasing the risk that they too will fail.
2. Concern over FDIC reserves hemorrhaging to more and bigger failed banks sparks a run on the entire banking system.
3. ObamaGeithnerBernake promises to print as much money as needed to deal with the crisis which in turn triggers a rush to exit Treasuries which effectively become junk bonds.
4. ObamaGeithnerBernake are forced to monetize the debt by having the Fed buy the T-Bills nobody else wants, massively increasing the money supply and triggering runaway inflation.
5. Deflationary pressure of massive credit contraction dukes it out with massive money creation/liquidity injection with inflation winning. Hyperinflation becomes the only way that the U.S. Gov can meet it's payroll.
6. through a freak shift in the space time continuum, Barack Obama and Robert Mugabe switch places. Nobody notices.
7. Foreign capital (what's left of it) flees the U.S. like rats off a sinking ship and civil unrest grows to ominous levels.
8. Rampant unemployment and a sinking dollar give rise to a populist revolt led by some horrible monster. The government response is to declare martial law and a police state is the result (no matter which side wins).
9. The U.S. breaks up into smaller regional governments which soon find themselves at war with each other.
10. The belligerents weaken each other to the point where Bearded Spock can emerge as the de facto ruler of the planet by virtue of being the Last Man (technically humanoid) Standing.
"Aw, c'mon. I want to know what, if anything, 'break the buck means. Or if that sentence can be saved."
I didn't know what it meant either, but I took sixty seconds to google it because I am not a lazy, slothful pathetic slug.
Experts, so called, are saying 'stay away from the dollar store'. If citigroup is allowed to fail does the fed go in and recover its investment or does it step aside and allow the FDIC to do its thing? It appears that somebody has to lose. If allowed to fail, does the fed try to protect the investor or the tax payer. Either way one or the other has to lose. Who chooses who loses. I want to roll the dice and buy citigroup...somebody tell me why not.
Please, we're not the greatest entities in the world, but comparing us to that guy is hate speech!
Blah, blah, blah, blah.
It must be possible to get clearer answers to much of this. Take the Lehman failure and the commercial paper market. The market is, say, $1700 billion, of which non financial business is about $140 billion. Presumably that's the part that has to make payrolls. Did it freeze up? Or was this just more problems for financing liquidity for the investment banks, while non-financial business went merrlly on its way?
Re Citibank. The popular take seems to be that their operations are so intertwined that nobody knows what would happen if some one part collapsed. Is that so? Prove it; I'm skeptical. I'd like to see the Fed/Treasury sort out the parts, identify the losses and potential losses (with numbers) and tell us what's really going on here. Then I'll believe, or not believe whatever is proposed. On that subject, this Administration promised us the most transparent governance in the history of the republic; so far, on this stuff, it's been about as transparent as mud.
"Aw, c'mon. I want to know what, if anything, "break the buck" means."
Money market fund shares are normally priced at a dollar per share and normally don't fluctuate at all. That's the point of them: they are supposed to be a virtually risk-free investment with daily liquidity, i.e., if you invest $500 in a money market fund tomorrow you get 500 shares, and if you want your money on Friday, you ought to be able to redeem those 500 shares for $500 dollars, plus whatever negligible interest your shares accrued. "Breaking the buck" would be if you tried to redeem your 500 shares and the fund company gave you less than a dollar per share back. That's what happened with Reserve Funds last year (which happens to be the company that invented the money market fund in the first place).
The fundamental mistake was trying to save individual banks. The bailout should have been to only insure that the senior lenders, the depositors and the account holders for the entire balance on their accounts. Had that been done instead of trying to save individual banks, the panic and runs would have been completely avoided allowing for an orderly unwinding of the insolvent banks. If this had been done, the cost would have vastly less and the clean up a lot easier and smoother. The good assets would have been sold at decent prices and the toxic assets would have been properly valued and sold off to investors willing to take the risks for a chance at outsize returns. The way markets should function.
Lehman was also a mistake. True they made huge and ultimately wrong bets but they were also a marker maker. Their collapse help trigger the collapse of AIG, the bookies bookies bookie. AIG failed to understand the risk they were insuring and the possibility of a cascading wave of bets being called. Again the regulators failed to properly regulate and the politicians in their rush to do something and avert a panic started the avalanche. Hanging Lehman was a very, very bad mistake.
Done is done but the same mistakes do not have to be repeated. The government can still guarantee the depositors in full and help smooth the clearing of the toxic banks assets by winding down banks that cannot survive. Interesting that Clinton wonder boy Rubin has a very large role in Citibank's demise.
There's one other pretty obvious question to ask: What happens if we continually support failed businesses financially, allowing them to keep the management team responsible for the failure in place and thus continue business as usual while rewarding incompetence? This is more of a long-term question.
Oh, and we know the answer. For those still wondering, just look up "communism" in the encyclopedia. It, um, didn't fare so well...
The net effect would be salutary.
The negative -- fear of specific loss -- would be more than offset by the manifold benefits of clarity. The market would understand that (1) Darwin will swiftly sort wheat from chaff in the financial markets, (2) fundamental analysis of credit will be rewarded, and (3) risk will be paid appropriately.
Although I have (for me) a lot of money invested in muni bonds, with a bit more in mutual funds, I really don't have much of an idea of what I'm doing. I came here from Instapundit. You guys, each and every one of you, are impressive. You all comment with logic and facts, even though you sometimes differ. As an engineer, I like numbers, probabilities, and trends. I really don't know how you guys sort all these imponderables out. I repeat, you are all awesome.
Warren Buffett has noted that it took Berkshire a very long time to unwind the derivatives of General Re after Berkshire purchased them. It was costly and time consuming, even though it was done in a peaceful market in a controlled manner. It lost a lot of money. Buffett's point was that if this was done during a disaster and in a hurry, it would be very ugly.
Years ago, I thought it was a bit too much when Buffett called derivatives and the whole ongoing game financial weapons of mass destruction. Now it seems like once again, Buffett was right.
Citigroup is not a comatose patient here. What they should be doing is offering to sell bits and pieces of themselves in order to raise funds. In fact, they seem to be doing that. If we can avoid a panic while Citigroup raises cash by selling assets, we will either be able to forego the panic entirely or the consequences will be much less dire because, put simply, Citigroup will be a smaller, much less complex, much less vital part of the financial landscape by 2h 2009 than it is today.
So the answer to what happens if Citigroup fails is highly dependent on *when* Citigroup fails. Had Pan Am failed in the 1950s instead of the 1980s, the consequences to the aviation market would have been huge. By the time they actually failed, it was barely a ripple.
So how much time does the rest of the financial market need to get out of the way of Citigroup failing? That's a question I'd really like to find out.
Worms eye view here:
My home mortgage is being carried by Citi. If they go belly up, then I suppose my loan will be bought as part of a package by someone else. Who is most likely? Freddie or Fannie? Chinese Army financial group?
Posted by Old Country Boy | March 8, 2009 10:32 PM
I would be worried about those munis as well. Especially those from seriously mismanaged states like California, Illinois, New Jersey among others.
Cities can go bankrupt. States being sovereign cannot but they can default. A couple of years ago, this would comment would have been considered nut house talk. Unfortunately in light of the last 9 months it is no longer in that realm. Stick with states like Texas that do not have an income tax and generally prohibit state indebtedness or munis that are backed by specific revenue streams like toll roads. At this point until the matter is cleared up, insured bonds mean nothing since the insurance companies that provide the risk guarantee are themselves shakey.
Think the big difference between Lehman and now is the FDIC backed debt program. Under normal circumstances with stocks getting hit hard and trading down to low single digit levels, banks would find very limited opportunities to raise capital except to borrow on a secured basis at the Fed window. In a case like that banks likely would run out out of collateral fast given increased haircuts on the collateral and deteriorating asset levels. With this program, the government ensures the banks can continue to operate until the Fed or FDIC unilaterally act. This coupled with the FDIC insurance of an unlimited amount on commercial checking accounts also prevents a Wachovia-like liquidity run. The government in the form of the FDIC are not capable of taking over banks of any real size (see Indymac) and the shockwaves of doing so would destroy confidence and continue the spiral we're in. Yes credit is deteriorating but politicians are acting irresponsibly by batting out a term like nationalization that has very different meanings (majority stock ownership, conservatorship, etc) and is contributing to the scare and negative confidence out there. The yield curve is about as steep as it will ever get (deposits are costing under .5% now while loans are above 5%) and banks should be given some time to try to earn their way out rather than being encouraged by politicians to give loans to people who didnt deserve them in the first place. If the Fed thinks AIG is a systemic risk, C is much bigger and BAC is even greater. Can you imagine the circus and financial debacle a government takeover of either institution would entail?
The way I see it, the government has three options right now.
1. They can let the banks fail.
2. They can bail out the banks with Treasury debt, let the Treasury fail, and then let the banks fail.
3. They can bail out the banks with Treasury debt, rescue the Treasury by inflating the dollar, let the dollar fail, let the Treasury fail, and then let the banks fail.
Three guesses which of these I prefer.
Is there any doubt that the problems of letting any of the major banks fail would be a catastrophic failure of foreign banks? Unfortunately, globalization has spread to our banks and the US can not let them fail - or many countries will fail, that is the major problem.
If this only affected the United States, they would let them go in a bloody minute...but unfortunately, many countries are involved. This is causing the immediate crisis and is also causing us to replace trillions of dollars to prop up these banks. Not looking like a realistic answer is available...
Interesting, to say the least. BTW, the phrase "Geithner et al"
is a bit amusng, as there seem to be no "et al". He has no
deputies about him now. I wonder who makes the coffee in his
empty offices?
I think that the Treasury and the dollar are quite capable of failing on their own without another bank bail-out. Basically I agree with your analysis, Brent, but I just can's see what could possibly halt the downward spiral we find ourselves in.
To be an optimist at this point basically you would have to make a series of assumptions:
A. This mess if fixable by a team of competent and wise people.
B. The people who now have the ability to control the system are actually these same competent and wise people
C. These powerful, competent and wise people also have the moral courage to make what are likely wildly unpopular but necessary changes to the failing system.
--or--
D. the system is magically self-correcting and will fix itself in defiance of common sense and the laws of mathematics.
Watching Geithner et al trying to halt the slide is sort of like watching that commercial of the Geico Gecko trying to catch the backwards falling CEO in a trust exercise.
When Japan had essentially this exact problem, Krugman went over there and said,"You idiots, you're in a classic liquidity trap. Inflate your asses off until the economy re-inflates, this will save the banks and solve your problem." Not so easy to escape liquidity traps it seems.
The problem with keeping banks afloat while they gradually recapitalize, is that they may recapitalize very slowly while taking massive transfusions of cash all the while and being a drag on the economy all the while (drinking money but unwilling to lend ...)
Why might this recapitalization take a long time?
Confusion, looting, and tunneling.
http://baselinescenario.com/2009/03/05/confusion-tunneling-and-looting/
Arguing over whether the government should, or should not, allow Citigroup to fail is pointless, since the government has already decided to do it.
Why do you think the FDIC has petitioned Congress for half a trillion dollars of funds?
Now, I realize that a trillion is the new billion in our nation's capital, but half a trillion dollars is more money than even God has.
Here's how our government is working:
1) A decision is made
2) Money is set aside to pay for that decision
3) Trial balloons are floated to give the astute time to liquidate their risk
4) The non-astute begin talking about whether the decision would be good or not, in theory
5) The actual decision is announced while the non-astute are still wondering how it happened so fast
Citigroup is gone. The FDIC has already prepared for it. If you are a US Senator, you don't openly and on national television say that the bank is done for (as Alabama's Shelby did) unless your aim is to create a run on that bank.
Which is exactly what will happen at 9am Monday morning.
Grim triggers are only grim triggers if you actually pull the thing when you get to the node.
The grim trigger of capitalism is liquidation, that is the entire point of free enterprise. If you succeed you keep the profits, but if you fail you are liquidated.
If we establish the precedent that insolvent firms will not be liquidated then that will literally be the end of the market economy in America. The government will raise taxes and print money on the productive enterprises to prop up every major failure, and with every major failure they gain greater leverage over the firms. Bailout will follow bailout until either the government owns the means of production or we are using Zims for money.
Does anyone in Washington have the nuts to the pull the trigger? Probably not, and that's why I'm in gold...
Plan to deal with Citigroup.
1) Geithner shows up at the next Citigroup board meeting.
2) Geither shoots Vikram Pandit in the head.
3) He tells the rest of the board he has a one job opening to run the company, and everybody else dies.
4) He throws a pool cue into the room and says "Impress me."
5) He locks the doors.
At least it would be interesting.
Thanks for clarifying a major misunderstanding of mine -- I thought that Citi(Whatever) was a bank, not an amalgam of variegated financial services, among them insurer, CDS-seller, etc.
Is the bigger lesson of this crisis that regulators should forbid a banking entity to engage in all these activities? Banking should return to the stodgy, bureaucratic business it had been before the roaring 1980s and later. No more "one-stop" financial centers. No more vacuous DABA girl groupies.
A second lesson for bank regulators, it seems to me, is never to allow a bank (or any other financial service for that matter) to become "too big to fail". If it's so big or so complex that the government fears to take it over and run it through an FDIC-style bankruptcy process, then it's time for regulators to step in and break it up into smaller pieces. At least, that's my take on this essay by notorious Red Diaper baby Thomas Hoenig, president of the Federal Reserve Bank of Kansas City.
City group has already failed be it not officially. The what if scenario is without merit. Allowing the biggest banks in America to fail at this junction after spending massive amount of capital on this is like buying a house and letting the bank to foreclose after paying for 75% of its value in cash.
One thing that can be done at this junction is to officially nationalize these banks and taking the bad assets off their books just to privatize them again. Many economist recommend this procedure because it is viable and least capital destructive.
The ring-fencing the bad assets is yet another solution to fence the bad assets while keeping these banks private but but it is ambiguous and subject to fraud.
One Eyed Man writes:
"Peter, I believe you are incorrect.
I'm pretty sure that secured debt holders of the bank are paid off by the assets of the bank before the depositors are."
That's wrong. The FDIC pays depositors in full up to their insured limit of $250k from an insurance pool. Banks pay premiums into this insurance pool to cover the costs. The FDIC enjoys the full faith and credit clause so if they ever need to borrow from the fed, they can.
Bond holders enjoy no such protection. In the event of a default, they effectively own the bank's assets. If Citi were to fail, the bank would declare bankrupcy and their assets would be sold with the proceeds going to pay off the bond holders and counter parties. The FDIC was set up after the great depression to provide insurance on bank deposits. It is not equipped to help bond holders.
Funny, a post about Citi posted this morning ET on this site with 40+ comments can garner only one comment that includes Senator Shelby's comments over the weekend. I wonder what this post would have looked like if Senator Schumer had said exactly the same thing.
All I want to know is what would happen to my pension from Citicorp. It would blow a pretty big hole into my monthly income. Would the goverment pension board take this over at about 40cents on the dollar? Or would it continue to receive my pension from ????
Citigroup stock is up 36% right now, on news by Pandit that the company made money so far this year.
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