Citi

by hilzoy

From the WSJ:

"Citigroup Inc. is nearing agreement with U.S. government officials to create a structure that would house some of the financial giant's risky assets, according to people familiar with the situation.

While the discussions remain fluid and might not result in an agreement, talks were progressing Sunday toward creation of what would essentially be a "bad bank." That structure would help Citigroup cleanse its balance sheet of billions of dollars in potentially toxic assets, these people said.

The bad bank also might absorb assets from Citigroup's off-balance-sheet entities, which hold $1.23 trillion. Some of those assets are tied to mortgages, and investors have worried such assets could cause heavy losses if they land on the company's balance sheet. Citigroup also has about $2 trillion in loans, securities and other assets on its balance sheet as of Sept. 30. (...)

Under the terms being discussed, Citigroup would agree to absorb losses on assets covered by the agreement up to a certain threshold. The federal government would cover losses beyond that level, people familiar with the matter said. One person said the new entity is expected to hold about $50 billion of assets."

The NYT adds:

"If the government should have to take on the bigger losses, it would receive a stake in Citigroup. The banking giant has been brought to its knees by gaping losses on mortgage-related investments.

Regulators were debating various terms of the arrangement on Sunday, including whether the government would receive preferred stock or warrants, which are instruments that give holders the right to buy stock. Preferred stock would be more beneficial to taxpayers because Citigroup would pay dividends on those shares; warrants would be more attractive to Citigroup’s existing shareholders, since they would not immediately dilute the value of their investments as much as preferred stock."

CNBC reports that the government has cold feet (h/t Calculated Risk). I suppose we'll know sometime before the markets open tomorrow.

Question: is there some reason not to hurt the shareholders? My assumption throughout has been that it's important to try to prevent moral hazard: we do not want people taking risks on the assumption that the government will step in and bail them out. When a bailout is required, we prevent the normal market response to dreadful management, namely bankruptcy or heavy losses. We therefore ought to try to impose costs on the people who could have and should have prevented it. This would include management, the board of directors, and shareholders. (Shareholders could not immediately prevent it, but they should not willingly invest in companies that are taking undue risks. One of Citigroup's problems is that its stock is now below $4 a share; had investors priced its risk accurately to begin with, it might not need a bailout today.)

For this reason, I don't see why hurting the shareholders is something we should be trying to avoid; offhand, I would have thought that mimicking the pain shareholders would feel if Citi went bankrupt was something we should actually aim for in constructing a rescue package. What am I missing?

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Further reading: This piece from the NYT is a good explanation of how Citi got into trouble (though Brad DeLong disagrees.) This is a good rundown of some of the problems it's facing, as is this. If you're wondering why Citi needs to care about its stock price, here's an answer. (Point worth noting: some institutional investors have to sell when stocks fall below $5. Institutional investors hold 64% of Citi's stock.) Henry Blodget on 'Six Ways Feds Might Bail Out Citigroup'.

And for an unrelated bit of gloom, here's a piece wondering whether GE is in trouble too.

Enjoy!