Who Bears the Burden for a $3 Trillion Mistake?

Citigroup plunged 39% on Friday to $1.50, a price last seen in 1992.

The plunge was in response to a Citigroup U.S. Accord on a Third Bailout that will convert the government's preferred shares to common, thereby diluting existing common shareholders and exposing US taxpayers to more losses.

Citigroup Inc. and the federal government agreed to a third rescue that will give U.S. taxpayers as much as 36% of the bank but expose their ownership stake to greater risk from the recession and housing crisis. The deal will punish existing shareholders of Citigroup, who will see their stake diluted by 74%, and likely do little to change the awkward relationship between federal officials and management of the New York company.

Depending on how many current holders of Citigroup preferred stock agree to a similar move, the company's tangible common equity could surge to $81.1 billion from $29.7 billion at Dec. 31. That would reverse the recent slide in tangible common equity -- a gauge of what shareholders would have left if the company were liquidated -- that fueled a downward spiral in Citigroup shares.

The conversion leaves taxpayers exposed to the risk of greater losses. The government's preferred holdings had stood ahead of common stock in Citigroup's capital structure, meaning they were less likely to lose value if the company's woes continue to mount. In addition, by converting much of the U.S. stake to common shares, Citigroup won't have to pay the hefty dividend payouts that were attached to the preferred stock.

"The government is bending over backwards to not go along the lines of nationalization," said Bernie Sussman, chief investment officer of Spectrum Asset Management, a unit of Principal Financial Group Inc. that manages about $6.9 billion in assets. "They had the alternative to completely zero out the common stock."

Mysterious Plans Revisited

Let's take a look one more time at Krugman's article Mysterious plans

What Treasury now seems to be proposing is converting preferred to common.

[Mish: No longer a proposal but a done deal]

It’s true that preferred stock has some debt-like qualities — there are required dividend payments, etc.. But does anyone think that the reason banks are crippled is that they are tied down by their obligations to preferred stockholders, as opposed to having too much plain vanilla debt?

I just don’t get it. And my sinking feeling that the administration plan is to rearrange the deck chairs and hope the iceberg melts just keeps getting stronger.

Shared Sacrifice

I had the pleasure of meeting Michael Mandel, chief economist for BusinessWeek, at a economic conference sponsored by the Kauffman Foundation last Thursday and Friday. I spoke with him at great length about the preferred conversions at Citigroup.

Mandel advised what was happening could be found in column he wrote last October called Shared Sacrifice Will Ease the Credit Crunch.

Over the past four years the U.S. private sector has borrowed an astonishing $3 trillion from the rest of the world. The money, directly and indirectly, came from countries such as China, Germany, Japan, and Saudi Arabia, which ran huge trade surpluses with America. Foreign investors trusted their funds to U.S. financial institutions, which used much of the money for mortgage loans.

But American families took on a lot more debt than they could comfortably afford. Now no one is sure how much of that towering sum the U.S. is going to pay back—and all the uncertainty is roiling the financial markets.

The Washington bailout debate boils down to this question: Who is going to bear the burden of the $3 trillion mistake?

Will low- and middle-income borrowers have to cut back on spending to pay their mortgage bills? Will taxpayers have to chip in big bucks to pay for defaults on those debts? Or will Washington act in a way that imposes large losses on foreign investors—in effect, repudiating some of the debt? The best outcome is shared sacrifice among borrowers, taxpayers, and foreign investors—but that result may be politically difficult to achieve.

Too Big to Bail

The next piece of the puzzle can be found in the Institutional Risk Analyst article Too Big to Bail: Lehman Brothers is the Model for Fixing the Zombie Banks.

Remembering that half of the liabilities of C, BAC and JPM are funded out of the bond markets and not via deposits, it should be clear to one and all that the US taxpayers are not in a position to subsidize the bond holders of these three banks, representing some $1.5 trillion in debt, if the deposits of these banks are to be protected. Some people, indeed, many people believe that we must avoid another Lehman Brothers type resolution where bondholders take a loss, but to us the only scenario where depositors of C, BAC, JPM do not take a loss is if we haircut the bond holders.

There are no easy answers here, but the guiding principle left by the Founders that bankruptcy be used to quickly and finally resolve insolvency is instructive. In that sense, Lehman Brothers is the ideal example, not something to be avoided.

What is required in Washington is an adult conversation, between the US government on the one hand and the holders of the bonds of the largest banks on the other. Many of the bond holders of the large banks are foreign governments, central banks and investment funds and not a few of these sovereign names are in really serious financial difficulties. Since the receiverships for Lehman Brothers and Washington Mutual, where bond holders took a near total loss, these foreign investors have been vocal in demanding that US taxpayers protect them from further harm.

But to deflect these cowardly, expedient arguments, the US government must be willing to lead by example to show that there really is only one way to restore confidence in zombie banks: use receivership to wipe out the common and preferred shareholders, conserve the deposits and sell the good assets to new investors, and then restructure the remaining operations of the bank to maximize recovery to the bond holders and other creditors.

Frogs Slowly Boiled In Order

Finally, in The Great Repudiation Revisited, Mandel mentions the above Institutional Risk Analyst article and concludes "At some point the bondholders are going to have to take a big haircut."

We can now see that the plan is to slowly boil the frogs in order. In other words, the government preferred shareholders need to be wiped out first in a manner that offends foreign investors the least. That manner was to wipe out US government (taxpayer) preferred shares along with foreign governments common equity and preferred positions.

The next frog to be boiled will be after Citigroup fails the stress test. At that point, there will be no way to avoid "an adult conversation" between the US government and foreign bondholders.

Meanwhile, the government is avoiding an outright nationalization of Citigroup hoping to avoid pressure by foreign governments for the US to make good on a full repayment of bank bonds. If the government limits its stake to 40% or less, US Government guarantees of bank debts may be skirted, or at least postponed.

Tying it all together, what's really happening has nothing to do with the announced plan to boost banks' TCE, tangible common equity. Rather, the plan is to repudiate the bondholders, step by step, boiling each frog in order, hoping to minimize the fallout from foreign bondholders.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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