This morning’s Citi announcement puts us one step closer to the moment of truth for the U.S. financial system. The key is not whether to nationalize or not—the government has made it clear that it will do whatever it takes to keep Citi and the other large banks afloat.
The real question: Who will have to take the hit? I can’t do any better than Peter Coy’s story here).
The key to understanding the nationalization debate is to focus on who will bear the pain of bank restructuring: Will it be mostly taxpayers and common shareholders, as it has been so far? Or will the pain be shared by preferred shareholders and even some classes of creditors, ranging from foreign bondholders to other banks to the counterparties of exotic derivative contracts?
I think this morning’s announcement effectively puts the arm on the preferred stock holders (such as the Government of Singapore Investment Corporation, and as the Citi press release puts it, “HRH Prince Alwaleed Bin Talal Bin Abdulaziz Alsaud” ) by forcing them to exchange their preferred stock for common, which now no longer pays a dividend. They have now absorbed some of the hit.
But Citi is still on the hook for $359 billion in long-term bonds (as of the end of the fourth quarter). In addition, Citi has the obligation to pay derivative counterparties an unknown and potentially huge amount, depending on how bad the economy gets.
So the government is now faced with two choices—to commit the taxpayer to make good on all of Citi’s risky bets, or to force some of these folks, the bondholders and the counterparties, to accept a big haircut.
There are no other alternatives. The bankruptcy option is out, because no one wants another Lehman. So it’s either door number 1 or door number 2.
Because many of these bondholders and derivative counterparties are outside the U.S., it’s also going to be a phenomenonal foreign policy mess. How does the U.S.—the richest country in the world and now the effective owner of Citi—say that it can’t pay back its debts?