The News Gets Worse

I'm lying in bed with a temperature of 102' reading the business press on Citi II, the second unprecedented bailout of Citigroup in less than six weeks.

The federal government has now committed nearly $350 billion to Citigroup alone in direct capital infusions and guarantees on Citi's "toxic" and potentially toxic mortgage-backed securities portfolio. This is bad news - - despite the rosy reaction of stock markets around the world.

First, it is now obvious the Bush Adminsitration's ever-evolving "TARP" program was never up to the task. The federal government found it necessary to guarantee over $300 billion in Citigroup debt-backed assets to make Citigroup sufficiently credit-worthy to borrow from other banks -- its only hope of remaining a going concern as an international bank. As the other major banks line up to strike similar deals - - and they must - - the TARP's original claim that there were $700 billion in toxic assets out there will be revealed for the arbitrary and naive number it was.

Nor is Citigroup yet out of the woods. These capital infusions and guarantees are only meant to create some kind of floor under it's mortgage-backed securities exposure and provide the liquidity to make Citigroup a less risky borrower on the world's capital markets. Citigroup's other questionable loan portfolios - - particularly its credit card, commercial real estate, and other securitized debt - - will continue to sour as economic activity slackens.

The federal government is struggling on a daily basis to restore lender confidence and liquidity within the international capital markets. It has tried guaranteeing commercial paper, money market fund deposits, expanded FDIC deposits, interbank loans, and now finds it must place a floor under the mortgage-backed securities exposure of major banks. The evidence suggests the core purpose of federal government intervention is to do whatever is necessary to avoid another Lehman-sized bank failure. That's a reasonable goal, but we need to recognize it for what it is -- an ad hoc reaction to impending disasters as they arise.

However reasonable a goal in the near-term, the decision to forestall free market restructuring of these financial institutions has serious potential long-term implications. In other words, twice in the past six weeks Citigroup has reached insolvency - - its liabilities exceed its assets. The entire financial sector recognizes this and, understandably, won't lend to an insolvent bank or buy its short-term debt. Twice in the past six weeks the federal givernment has stepped in to pad the asset column with capital infusions exceeding $50 billion.

This time, the federal government has also guaranteed 90% of potential losses on over $300 billion of these assets at Citigroup, but they remain on Citigroup's books. It will take decades for many of these assets to be retired and Citigroup will have to retain reserves against these possible losses during that period -- money that might otherwise provide liquidity to the economy through business and personal loans. Repeat that same story among the other major banks and you can see how much dead weight in potentially bad loans will hang over the financial sector for years to come. There are no private buyers for these assets at this time at any price. Even the federal government backed off buying these assets from the banks after TARP was passed -- choosing less costly guarantees instead.

Normally - - and for smaller banks and businesses facing insolvency - - the liability side of the ledger is reduced through restructuring (selling off assets to pay down liabilities and focusing on a core business to generate sufficient cash to pay down the rest over time) or bankruptcy. The federal government has taken bankruptcy off the table for the likes of Citigroup. Without the fear of bankruptcy, the impetus to restructure is less urgent. In fact, the political will to tackle the extreme dislocations which may occur when the behemoths of the financial world all face insolvency simultaneously, and so must restructure simultaneously, can disappear. Faced with a choice between certain pain now and perhaps less pain extended into the distant future, most politicians will choose the latter. This is what happened in Japan, resulting in their infamous "lost decade," humbling an economic powerhouse thought to be more saavy and politically disciplined than the United States during its meteoric rise in the 1980's.

This is the real danger of these successive bailouts. We are watching the transfer of decision-making authority from the collective rough and tumble of the free markets to the White House. We know free markets can be brutal things and Citigroup filing for bankruptcy would likely shake financial markets to their core. We also know no White House will be able to resist the political pressure of major contributors for long - - allowing businesses which should have failed in a free market to drag on.

In sum, a pattern is emerging which strongly suggests the federal government will continue to prop up the biggest firms, encourage restructuring through mergers where solvent buyers can be found, and pour money into the capital markets in the hope greater liquidity and inflation eventually create a market for the toxic assets weighing down the big firms' balance sheets. The pattern strongly suggests we are reducing pain in the near-term, but extending it over time. Where "economists" a year ago questioned whether we would even see a recession, they now speak confidently about a recession lasting several quarters to a year. A year from now, they will be talking about an extended period of low- to no-growth stretching into the next decade. Five years from now, they'll be criticizing the powers that be today for showing too little resolve, propping up firms they should have allowed to fail.