Federal Reserve = Midden, Son of TARP?

December 2, 2008 at 7:36 am Leave a comment

Citigroup is being bailed out by Uncle Sam. The scheme to have this happen under the smokescreen of Citi “saving “ Wachovia was torpedoed when Wells Fargo bid for Wachovia without the requirement for government support. Plan B – have the Treasury acquire toxic assets under the TARP failed when the
plug on the TARP’s reverse auctions was pulled. So now we have Plan C – the public sector “guarantees”
over USD300bn of assets of Citigroup and explicitly puts in a slug more equity. The Federal Reserve
becomes the toxic waste dump of choice. Here’s the deal. Citi has identified USD306bn of “troubled” assets which the press release says have the “possibility of unusually large losses” and which comprise “loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup’s balance sheet”. Citi will absorb the first USD29bn of losses on these assets (in addition to existing reserves). The US government will take 90% of further losses, with Citi taking 10%. The US government in the shape of the TARP takes the second loss up to USD5bn. The FDIC takes the third loss up to USD10bn. The Fed finances the remainder with a non-recourse loan (NB this means if the assets go bad the Fed has no call on Citi which basically means the Fed takes the rest), subject to the 10% loss sharing. For this, the Fed will be paid OIS plus 300bp. The government will receive preferred stock of USD7bn at an 8% dividend of which USD3bn will go to the US government and USD4bn to FDIC.
What this means is that Citi’s potential losses on the pool of USD306 bn are USD56.7bn (=29bn + 10% of
USD277bn), the US government’s potential losses are USD5bn; FDIC’s are USD10bn and the Fed’s are 234.3bn. In other words, the bulk of the bailout is by the Fed, whose balance sheet is increasingly
compromised as time goes by. We have no problem with central bank balance sheets being used to provide short term liquidity, but since these guarantees run for 10 years for residential assets and 5 years for non-residential this is a bit more than short term.
It seems likely that many of the assets financed by the Fed will go bad. The end-result is that the Fed will not have provided loans to Citi, but will have injected equity and that equity will have been wiped out. If the assets are subject to “unusually large losses” getting the central bank to finance 77% of them on a no-recourse basis (i.e. putting its own capital at risk) is compromising not only the central bank’s balance sheet but also its conduct of monetary policy. This is the main feature we find objectionable. 

Additionally, the Treasury is to supply USD20bn of additional capital to Citi in the form of preference shares, at an interest rate of 8%, which only recently received USD25bn under the TARP. These funds are under the TARP, Dividend payouts will be limited to a cent per share per quarter, except if the Fed, FDIC and government agree otherwise (and issuing additional capital is one factor they will take into account).
The alternative to this would presumably have been an intensification of the pressures that were evident in the markets last week and maybe the risk of a failure. The plan looks much better than that and so the principle of the bailout is very much to be applauded. The markets have welcomed it (including Citi’s shares, which should be expected since the plan is generous). But as with so much with the US rescue, the details can be heavily criticised. In particular, TARP is not now acquiring toxic assets, but the Fed is. This is to be regretted deeply. The central bank should not used as a midden. I can’t help thanking my lucky stars that I am not a US taxpayer because the plan looks like a potential injection of capital of massive proportions, depending on how toxic the toxic assets the Treasury is underwriting prove to be. Many questions are
unanswered, including:
1. What is the mark to market value of the USD306bn of assets the public sector is guaranteeing?
2. What are the estimated losses on a fair value basis expected to be?
3. Were prior to the agreement the USD306 bn of assets covered on-balance sheet or off-balance sheet (the WSJ reports that Citi has some USD2trn of assets on balance sheet and some USD1.3trn off balance sheet).
4. How much more of toxic assets does Citi have both on balance sheet and off balance sheet and what is the plan to deal with these?
5. What are the details of the warrants the US is acquiring in terms of exercise price and other details? Isn’t USD7bn a remarkably small amount given the potential loss to the US (Fed, Treasury and FDIC) of USD 250bn?
6. Why is the Fed being used as the main guarantor of the deal? This may be to avoid Congress kicking up rough as there is not enough left in the first tranche of the USD 700bn agreed under the TARP banner. The Fed is too often s a way of circumventing Congress, which compromises its balance sheet (and some would say compromises the will of Congress too).
7. How will the Fed finance the loan it grants to Citi?
8. If the loan by the Fed is not repaid in full how will the Fed make good the erosion of its own capital base?
9. Why is there a guarantee of assets rather than a bigger capital injection? Isn’t this just postponing the inevitable further injection of cash by the US government?
10. Why are not Citi shareholders contributing more capital? The US has put USD45bn in over a very short period and has now guaranteed another USD306 bn of assets, which looks like a disguised future contingent capital injection of a much larger size. (In fact, the conditions under which dividend payouts are limited suggest the US government is pressing for issuance of common stock).
11. Doesn’t this demonstrate exactly what we said about the original capital injection plan – it’s too small and will have to be increased? When is the US Treasury going to admit to the actual size of the problem and take decisive steps to deal with it properly rather than reverting to piecemeal steps? How much will this cost?
12. Who’s next? Capital injections so far are insufficient and much more needs to be done to stabilise the system.

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