SIGTARP on Citi Rescue: Ignoring a Bomb That Has Yet to Be Defused

On the one hand, I must confess to a “I love the smell of napalm in the morning” response to reading the SIGTARP report on the extraordinary assistance extended to Citigroup, starting in November 2009. The well-documented, blow by blow account, taken from the perspective of regulators, dovetails neatly with the reports here and on other blogs during those fear-filled, gripping times. (As an aside, frustratingly, the media is treating some factoids in the account, such Citi’s reliance on over $500 billion of uninsured foreign deposits out of a $2 trillion balance sheet, as news, when it was noted repeatedly in the blogosphere, particularly here).

But on the other hand, the SIGTARP report is annoying, in that it fails to connect some critical dots, diminishes the importance of its key finding, and is far too complimentary to the officialdom.

It’s odd that the reports of the Congressional Oversight Panel are consistently more hard-hitting than those of SIGTARP. While most commentators were pleased with its report on AIG (it correctly criticized Geithner for failing to renegotiate the credit default swaps payouts to AIG counterparties, we found the report pulled its punches and incorrectly backed the Fed on its retrading of the AIG financing.

Let’s start with the backwardness of the reasoning of the report. It seems that the process of putting together this detailed account produces similar results to embedding journalists in military operations. There is way too much sympathy for the viewpoint of the regulators, when the very fact that Citi needed to be rescued is a clear sign of massive failure of oversight and imagination.

The report’s two beefs, which it goes to some lengths to treat as secondary, wind up being overly mild. One that the assessment of Citi was too “ad hoc”, which really means qualitative, and this finding, which ought to be the centerpiece of the report:

While the year-plus of Government dependence left Citigroup a stronger institution than it had been, it remained, and arguably still remains, an institution that is too big, too interconnected, and too essential to the global financial system to be allowed to fail.

When the Government assured the world in 2008 that it would use TARP to prevent the failure of any major financial institution, and then demonstrated its resolve by standing behind Citigroup, it did more than reassure troubled markets – it encouraged high-risk behavior by insulating the risk takers from the consequences of failure. Unless and until institutions like Citigroup are either broken up so that they are no longer a threat to the financial system, or a structure is put in place to assure that they will be left to suffer the full consequences of their own folly, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results. Notwithstanding the passage of the Dodd-Frank Act, which does give FDIC new resolution authority for financial companies deemed systemically significant, the market still gives the largest financial institutions an advantage over their smaller counterparts. They are able to raise funds more cheaply, and enjoy enhanced credit ratings based on the assumption that the Government remains as a backstop. Specifically, creditors who believe that the Government will not allow such institutions to fail may under price their extensions of credit, giving those institutions access to capital at a price that does not fully account for the risk created by their behavior. Cheaper credit is effectively a subsidy, which translates into greater profits, giving the largest financial institutions an unearned advantage over their smaller competitors. And because of the prospect of another Government bailout, executives at such institutions might be motivated to take greater risks than they otherwise would, shooting for a big payoff but with reason to hope that if things went wrong they might still be able to keep their jobs.

Citigroup was, and remains, a unresolved problem, the poster child as to why the Dodd Frank special resolution authority will be a non-starter for TBTF banks. The report includes some of the reasons why yet fails to draw out the implications.

The biggest impediment, as we harped on repeatedly in 2009, is the magnitude of Citi’s foreign deposits. There is simply no way it would be acceptable for US taxpayers to bail out uninsured foreign depositors. Yet the magnitude of that source relative to Citi’s total funding means that a run on those deposits would take Citi down, pronto.

And anyone paying attention could see the behemoth bank was fragile. One of the failing of the report is its too narrow time frame. It deals with fall 2008 and the aftermath, when Citi was clearly in trouble long before that (and we don’t mean its 1990 near death experience). An ongoing soap opera in the fall of 2007 was Hank Paulson’s futile efforts to find a private sector solution to the problem of structured investment vehicles. These supposedly off balance sheet vehicles which typically included risky residential real estate debt among its holding, were funded with commercial paper. It turned out these SIVs were funded by influential enough investors that they were able to demand that the banks take responsibility for their problem children.

Citigroup, the biggest player in the market, with $100 billion of SIVs outstanding, was thus already known to be in bad shape when the crisis intensified. The report oddly focuses on the stock market declines (missing that CDS were the far better way to lay siege to an embattled financial firm), including an effort by Bob Rubin to get the SEC to reimpose the uptick rule to make matters more difficult for short sellers. But it misses some of the news stories that heightened concern about Citi, one of them being the famed liquidity puts. A November 11 Fortune story gives a snapshot of the bank’s deteriorating credibility:

Last summer, with the whole world suddenly unwilling to finance CDOs, the holders of the liquidity-put CDOs began to return them to Citi. And that’s where they now reside – $25 billion of them, a very large lump in Citi’s $55 billion of subprime-related securities. That entire package of trouble was the subject of Citi’s Nov. 5 analyst call. This was the third presentation that Citi had made to analysts in five weeks – each of these confessionals more anguished than the last – and in that time Citi’s stock and Prince’s credibility had been punished.

The report makes much of the regulators’ lack of quantitative measures to determine whether the bank was a systemic risk. That’s a red herring. With so much of Citi’s business taking place in over-the-counter markets (where estimates of market size are typically vary by a factor of three or more), it’s difficult to come up with anything other than fairly crude estimates for their role in various markets.
And even those can be misleading. Two firms with the same level of customer trading in a particular market will have different risk exposures if one is providing a lot of financing to their positions and the other is not. And Steve Waldman has described at some length why putting numbers on bank equity is an exercise in fiction, not math.

In other words, it’s far more fair to criticize the authorities for their ad hoc and inconsistent responses to tsuris at various financial firms rather than the lack of hard and fast rules for determining which player poses systemic risk. Judgment will always play a major role.

Citi was, and remains, a menace. And the reason it can’t easily be disarmed is its Global Transaction System, which is an international platform used by major corporations for funds transfers and balance reporting. The report fails to stress that that GTS is the big reason that Citi has such large foreign deposits. As we noted last year:

GTS is a big piece of what makes Citi a difficult to disarm bomb. One of the swords of Damocles that the big bank had over the officialdom is that, prior to the crisis, it had $500 billion of uninsured foreign deposits. If Citi looked wobbly, sensible depositors would withdraw funds, and that could quickly morph into a run. Moreover, the any other international bank with meaningful cross border deposits could come under scrutiny (although it is odd more of this has not happened in the wake of the implosion of Iceland, which left a number of UK borrowers high and dry until concerted pressure on Iceland produced some restitution).

The Journal argues that GTS is essential to Citi. This is rubbish. GTS is a sophisticated payments system and a source of low-cost deposits. It may provide a foot in the door, and help deepen some relationships, but let us face it, cash management and payments systems are at best assistant treasurer relationships at big companies. Proof of the pudding: it is a no-brainer that companies like Goldman, Morgan Stanley, Barclays, and UBS are doing complex, high margin transactions at companies that are also using GTS.

We cannot afford to have critical, socially valuable, core banking services be used to fund high-risk activities that then put the provision of the core services at risk. So we have two choices. One option is to regulate the banks so as to severely restrict their risk-taking (which is possible but no one has the will to do it right now), and various bank activities would be defined so that it you engaged in them, you’d be required to be licensed and subject to the same rules. The other route is to make the TBTF bank less big and complex, so that resolving one would not be impossible. I’m skeptical of that approach, because the capital markets firms are still deeply enmeshed, so one going down runs the risk of taking down the entire grid.

GTS ought to be separated from Citi. As we argued:

But whichever way you come out on this question, Citi is too bloody big and complicated. Even though Citigroup is already in the process of scaling itself back to something resembling the old Citibank, even that is still a dangerously large operation. And now with Citi carrying a very large portion of its assets in Treasuries and liquid securities, it actually could afford to spin off GTS, since the bank is not funding as many illiquid positions as it once did (admittedly it would be operationally complicated, and Citi might need an transitional funding arrangement with GTS, but remember, we split up AT&T). That would have the salutary effect of improving the equity ratios of the rest of the bank (the money raised by the IPO would likely exceed, by a large margin, the value at which the unit is carried on Citi’s balance sheet now), and of eliminating the use of cheap foreign deposits to fund riskier activities which then are backstopped by the US taxpayer.

But now that the crisis has passed, and SIGTARP has given Treasury, the FDIC and the Fed for doing such a masterful job of putting duct tape and baling wire on a broken financial system, even the obvious and operationally not horribly measures that could be taken to reduce systemic risk will remain undone.