Monday, November 24, 2008

A Terrible Mistake?

Today it was announced that Citigroup, previously the largest banking concern in the United States, is going to be bailed out by the government. Upon hearing this, I immediately thought about a phone conversation that I had with a phone salesman in 2006. He had called me up to try to get me to buy gold bullion (pure gold coins) as an investment. I was somewhat interested, but was taken aback by the large mark-ups. The conversation continued in the following way:

Salesman: where do you have your money invested right now?

Jacob: in a savings account at Citibank.

Salesman: banks can go bust at any time!

Jacob: well, it is the biggest bank in the United States, and one of the biggest in the whole world, so I’m just going to stick with that.

Salesman: you’re making a terrible mistake!

Jacob: goodbye

It turned out that the salesman was completely right in doubting the viability of Citibank, although I’m not sure he knew why he was right. At the time, the summer of 2006, his ominous words of financial destruction would have sounded ridiculous to most people. At the time, housing prices had never been higher and the stock market was roaring towards the sky. Gold and savings accounts were only for losers and weirdoes.

The salesman sounded more like someone from the 1800s, when banks were printing their own wild cat money and really did go bust all the time because there was no regulation, and not even a central bank. More surprisingly though, towards the end of the 1800s, banks did get heavily involved in complex securities via bonds, not unlike those we are trying to deal with today. This started off a deep recession across the country in 1873.

Citigroup has a lot of problems right now, and although I suspected that the problems were big, I did not think they were this big. It appears that the estimated value of the toxic assets at Citibank is around $690 Billion! That’s almost the size of the entire government bailout package ($700 Billion). All these firms that have now been bailed out on a large scale have had the same pattern of behavior this year, and it goes something like this:

1. firm’s stock starts plunging 2. firm says that the financial state of the company is totally fine, and in fact, better than ever 3. stock starts plunging more, and firm blames it on short-sellers 4. firm requests government bailout and says it will go bankrupt within a week if it doesn’t get it.

This was roughly the pattern for Bear Sterns, Lehman Brothers and AIG. Last week, Citibank said that short-sellers were responsible for the plunging stock, but a detailed analysis of the trades revealed that only 2% of the volume was made up of short-sellers, so this could not possibly have been the case. In other words, Citibank was desperate. At any rate, the government approved a bailout of Citibank extremely swiftly, and has now injected $45 Billion into the bank, and is guaranteeing over $300 Billion worth of losses. I think this had to be done, but for the future, this must be discussed further. The most important thing to remember is that:

the government has no idea what it is buying

When the government decides to “guarantee” toxic securities for companies such as AIG or Citibank, it does not actually go through what it is guaranteeing. If the government says that, for instance, AIG has $100 Billion in toxic assets that need to be guaranteed, it has no idea whether $100 Billion is the correct number, or what these assets are made up of. The reason is that, because these bailouts supposedly need to happen right away, there is not nearly enough time to go through the books of the companies. If the government were to have gone through AIG’s assets to see what was toxic and what was not, it literally would have taken many months, if not over a year. So, what actually happens when a company like Citibank asks for a bailout, is that government representatives and bank representatives sit down and discuss the assets without actually looking at the books.

Consequently, the government has to take the bank’s word for how many toxic assets there are and simply give them the money. There’s no other way now that things have gone so far. This leads one to the obvious conclusion that there is no way to know: 1. whether the bailout is going to work, or 2. whether more bailouts are going to be needed (which is almost always the case because the banks are lying to protect themselves).

These toxic assets have made their way into almost every diversified investment portfolio in America, from pension funds, college savings accounts, mutual funds, bond funds, and even treasury bonds funds. How did this happen? Well, a lot of these types of investments, such as pension funds, can only legally invest in products that are rated “Triple-A”. That basically means that the product is supposed to be a solid investment. The toxic assets that are now worthless were rated Triple-A, which can be a little hard to believe. The complexity of these toxic assets was the key to getting them this highest of ratings.

Just like the government, the ratings agencies did not bother going through the products that they were rating, because it would have taken too long. Also, the institution that was offering the toxic asset was paying the ratings agency for the rating, and probably bribing it on many occasions. Result: almost the entire American population lost money that it could not afford to lose on this giant pyramid scheme, and after that became clear, the taxpayers had to pay to clean up the mess. Hence, many taxpayers are paying to cover their own losses, and are being hit twice.

Reagan decided to start taking the country back to the 1800s in terms of financial regulation, and by the time Bush and Greenspan had had their say, the country was almost back where it was in the time of Andrew Jackson (a very strong opponent of regulation). It is surprising to me that all confidence in the financial markets is not lost as of yet. The American people still seems to believe that things can go back to the way they used to be. Trust me, for the next 10-20 years, they cannot, and will not. In the meantime, we need to learn a few lessons from the banking customer of the 1800s: be extremely skeptical of banks, and don't invest a dime in the stock market. For the future, we need an enormous amount of new and uniform financial regulation, new taxation on all kinds of investments in financial products, and an entirely new infrastructure for financial oversight.

The good news for Citibank’s customers is that their deposits will be safe, for the moment, through the FDIC insurance. It turns out that I did not make “a terrible mistake” after all, like the salesman warned, but I came pretty close.


movie buff said...

my initial thought upon hearing about Citibank's potential bankrupcy was, Yipee! this will cancel out the small fortune's worth of debt I have stored up on my trusty Citi-card... right?

Jacob said...

Well, it's actually not impossible that that could happen, but it is rather unlikely. When companies go into bankruptcy liquidation it's not that uncommon that debts are forgotten about or lost. When debt is your entire business idea, however, I would think that the people involved would keep track of it.

Lisa M said...

Jacob, I saw your comments in the NYTs today. I was thinking similarly, that it's surprising the stock market isn't closer to Zero right now. But I think perhaps the reason stocks are hanging on has to do with the economic staff Obama has just named. These guys are all business-as-usual players and whether they're really good picks for getting us out of the mess or not, these appointments are reassuring to [the jaded minds on] Wall Street. Personally, I think Obama should have brought in at least some entirely new people--some economists who are independent and were not a part of the past mindset and could provide some new perspectives and insight. Doesn't it seem to you that Obama appears to be veering too much into a "business as usual" mode?

Another question: now that we know what we know about Citibank, isn't our economic mess much worse than you thought it was a month ago? Do you still think the banks may be carrying between 30 and 60 trillion in debt related to the default swaps? Or do you think now it may be worse?

Jacob said...


yes, on the surface, it would seem that Obama is a little too much "business-as-usual", contrary to campaign promises. His staff has publicly come out and denied this as a result.

There is another possibility though, which is that Obama is trying to use the crisis to his advantage. Through gathering a team of insiders, swift and sweeping political action will be easier, as long as Obama is the one calling the shots.

Unfortunately, political change almost never comes in America through careful deliberation and discussion; it comes as a response to a crisis. I believe that is because of the weakness of the parties as entities, and the absence of proportional representation, but that's another discussion. By calling for stimulus and "down payments for the future" in health care, education and the like, he is combining crisis management with a progressive agenda, as others have done before. But I could be wrong...

In terms of the credit default swaps, I see no reason to believe that the amount of the problem is any smaller than it was per se, but there is one surprising development. It seems that some firms that are technically within their rights to receive payments for the CDSs (or insurance against their losses) they bought are not claiming the money from the seller. It's as if someone with a car insurance crashes his car and doesn't claim any money.

I'm not sure why this is happening, but I'll try to find out. Are Wall Street firms having solidarity with each other? Such sentiments are usually not prevalent on Wall Street.

Lisa M said...

Funny you mentioned the "party" system problem. I was just discussing that with a friend. We were of the mind that we'd all be better off without political parties. But certainly a good place to start would be to get rid of the two presently dominant parties. They've become so corrupted by special interests-- and this seems like the fundamental problem with our entire system.

As to the default swaps, this sounds like good news. Maybe the firms involved don't want to lay claim because it could bring on bad publicity. (If you read most of the comments in the Times today a lot of people are starting to scream for heads.) Another possibility is -- and I'm just taking a guess here -- they have so many shady investments going they just forgot about this one.

Jacob said...

That's a very good theory. It could very well be true

Dave Dubya said...

I am not clear on this economic mess enough to even form a sound opinion about what national policy is best about fixing it. I don't think there's a cure for greed; especially if the greedy and inept are rewarded with bailouts.

I do think it might be a good idea for people to learn a productive craft or trade so they can exchange what they've made or produced for goods and services from others. We may need to fall back on a type of local barter system.

As for me, I'm thinking about giving music lessons in exchange for good booze. ;-)