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!
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.
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.