The Problem With the Citi Bailout

We all know that Citi (C) was “bailed out” last week. However, as far as I can see, Citi’s is a unique situation for several reasons:

1. The company was not taken over, and
2. Management was allowed to stay on, and
3. The government is shouldering losses coming from securities that are already identified.

Taken together, these leave a huge hole in this “living bailout” (I call it that because, obviously, Citi was in dire straits but was allowed to survive, essentially, as it existed before) that, obviously, Treasury never thought out (setting aside my prior concerns). I’ll put the problem into a single statement…

When taxpayers agree to pay for losses of a company that is continuing to operate, but the losses being referenced pertain only to specific assets, there are a huge amount of games that can be played and the government has no way to stop or monitor what is truly going on.

As a matter of fact, as I write this the news of the G.A.O. report (PDF) on T.A.R.P. is making the rounds. One of the main criticisms is the lack of monitoring of bailed-out institutions. And those institutions don’t have explicit guarantees like Citi does.

It is extremely surprising to me that, for example, there aren’t auditors or officials from Treasury meeting with traders and executives of Citi’s mortgage groups regularly. As a matter of fact, I would station some people on the trading desks where these assets are being managed to give status reports and monitor the situation. Further, Hank Paulson’s and Vikram Pandit’s interests are aligned here. Vikram shouldn’t want these assets languishing or Citi being accused of sitting on assets that might lead to a taxpayer loss in the future and Hank Paulson should want to know Citi still feels some obligation to minimize taxpayers' exposure to losses.

Now, the question of what “games” can be played is the next natural question. Well, if I’m a trader, I mark my own position every day. In mortgages, there is little to no verification of these prices–the markets are so illiquid that only the people that trade the product know the actual value of a given instrument.

This conflict, in general, is controlled by the organizational structure: the person most likely to know the product as well as, if not better than, the trader is the trader’s boss. Obviously, the trader’s boss has little incentive to allow his employees to incorrectly mark the trading book because he can be held accountable. With this “living bailout” though, what incentive does Citi have to sell assets in a liquidity-challenged environment?

If no pressure is applied from Treasury, and how can they apply pressure without being deflected if they aren’t “on the ground,” then why wouldn’t Citi just hold assets they currently view as having positive value? Citi likely has assets that are obviously going to go bad, in which case there is likely no way they can offload those assets (perhaps around, oh, say… $29 billion worth…), and assets they view as merely undervalued due to liquidity concerns. Why would I seek out a guarantee on further losses for assets I can sell today? If losses are guaranteed then what’s my downside in just holding illiquid assets?

Because Citi won’t absorb all the losses on the assets viewed as undervalued, those assets are worth more to Citi than others. And, as a trader that gets paid based on his/her personal P&L, I have every incentive to avoid losses that I view as not being inevitable and I have a defensible reason to not mark my position merely to the price I can sell it today. Another nuance comes from how traders actually mark their books…

1. A trader buys mortgage bonds, loans, or any other security. The current profit or loss of that trade (we’ll call it “the bonds” or “the position”) is the purchase price and there is no net P&L.
2. The trader then enters into another transaction that is considered a hedge for the position. This transaction could be buying credit protection, shorting treasury bonds, or any number of other possibilities. We’ll refer to these transactions as “the hedges.” This trade generates no net P&L.
3. On an ongoing basis the position is marked “flat” to the hedges. This means that, dollar for dollar, any loss or gain in the hedges is added or subtracted from the original position so as to generate no net P&L. This isn’t perfect, but it’s theoretically very clean since the point of the hedges is to eliminate the risk in the position.
4. Generally, a price movement in the position that isn’t reflected in similar price movements in hedges is marked manually–usually this takes place at month-end. However, if the original position is sold then the difference between the most recent marked price and the sale price will generate positive or negative P&L as well.

So here’s a good question: Why does a trader, now, have any incentives to hedge? A better question, though, is why would I mark my positions accurately versus hedges? Can’t I make the claim that all the gains in the position, as evidenced by losses in the hedges, should be taken as P&L but only 10% of the losses, as reflected by gains in the hedges, should be taken as P&L?

Because the positions hedging the guaranteed mortgage positions are either derivatives or other products that likely aren’t also guaranteed, this asymmetry becomes problematic. It’s not even clear that whatever scheme generates the most profits for Citi isn’t the correct way to account for the gains and losses of a typical hedged mortgage position in this atypical arrangement. I know that traders are asking these very questions. However, the possibility that taxpayers could shoulder costs while Citi also books profits whose existence depends on taxpayer-funded guarantees is troubling.

I don’t think anyone would disagree that this arrangement is complicated enough that a higher degree of oversight is required (and should be desired by all parties) to ensure that nothing improper is going on for the sake of taxpayers and Citi’s reputation. One thing we’ve learned from A.I.G. (AIG) is that even if billions of dollars are at stake, expenditures on the order of one hundred thousand dollars can become P.R. nightmares.

Treasury should be auditing all of Citi’s mark-to-market procedures and setting standards to protect taxpayers (more so than non-”living” bailouts). Also, as I stated before, there is no reason that there shouldn’t be some sort of watchdog presence on the trading floors to ensure Treasury is keeping watch and being kept in the loop.

Disclosure: None

Comments

[otbricki:]

The bailouts are being structured to extract as much as possible from the American middle class as the Bush end game. The only choice Obama will have will be confiscatory tax rates on the wealthy in order to restore balance between classes in America.

Prepare for a lot of whining.

2008 Dec 03 09:23 AM

[JaymanThai:]

I think it was you or Bloomberg who said "forget the 700 billion" that Paulson has and is spending. He is in bed with and has been in bed with Citi since the overturn of the Glass Steagle act which enabled a financial insitiution to own an insurance company. This was previously against the law.
Paulson was also instrumental in the Commodity Futures Modernization Act of 2000 which enables the CDS sales to begin with.
We do not know anything and he knows less, But he has the money to give away to his friends and those who participated with him to destroy our previously healthy and protected economy.
Fight for our rights for full disclosure. Write your congressperson today.

2008 Dec 03 09:47 AM

[helplessobs...:]

There is no blood in the streets, but when all this becomes clear Paulson and his cronys had better be out of the country.

2008 Dec 03 12:07 PM

[Jan20cantco...:]

The Paulson/Bush "the sky is falling we must act now" fear-mongering to pass their bailout plan with no planning was ridiculous. Our politicians are not smart enough to understand anything that has been written in the article above. Scary enough that they are the ones in a full panic spending tax payer dollars and pushing our deficit to disgusting levels.

Anyone with half a brain knew that there was no oversight in these handouts to greedy executives. Having worked for Citigroup, if the government continues to hand them money with no regulation or oversight nothing will change. Same management, same problems. We need leaders who have the courage and intelligence to axe some executives and figure out the real problem. We let the oil industry rape America, now it's the financial sector and soon it will be the auto industry. And don't make me laugh with the suggestion that auditors are the answer. Why have we heard nothing about the audit firms that have been signing off of Citi's, AIG, GM... etc. books for years. Did you all read about the Executive Partner at Deloitte who was indicted for insider trading? These audit firms are a joke. They aren't the solution, they are part of the problem.

To listen to Bush in his "exit interviews" try to pin the financial crisis on Clinton is just disgusting. Bush has been in office for 8 years. He did nothing and now he's trying to blame this on someone else. Are you kidding me. We all inherit jobs and decisions that were made before us in any line of work. As things change sometimes you have to undo something that the person before you put in place. Your failure to do so is your responsibility.

I have no faith in government. The are all a bunch of crooks.

2008 Dec 03 01:03 PM

[monday1929:]

"Citigroups reputation"??? CITIGROUPS REPUTATION?????? The only reputation they should have is that of a criminal, and incompetent criminals at that. They pay hundreds of millions in fines every year for their crimes, always without admitting guilt- only the poor are unable to buy justice.
I have accused them, and JPM of being insolvent/bankrupt, using my own name and have challenged them to sue me- and reveal their hidden off-book "assets" in open court. They have not taken me up on my offer. Notice the (correct) assumption of this article that Citi will "game" any program put into place, and steal given any chance they get. And why shouldn't they- when caught the company pays a fine, they call their old university buddys and land another well paid job elsewhere.
Why would any fiduciary entrust one cent at JPM Citi or any other gangland bank? How can they justify risking client money now that their bankrupt condition is obvious? How could Bill Gross bet Billions of client money in bankrupt FNM/FRE and pray for (or receive illegal inside info of) a govt. bailout?
We must seize illegally obtained bonuses/pay going back at least 7 years, start RICO prosecutions of criminal banks and prosecute individuals who have committed financial terrorism.
And force executives to look up the word "honor" and write a one page paper on its meaning.

2008 Dec 04 08:41 AM

[farmer448:]

So how does Citigroup buy a Spanish Outfit?

2008 Dec 04 10:01 AM