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Monday, February 23, 2009

Selective nationalization

Citigroup will apparently receive the latest in a series of rescue packages from the government.  In October, they received $25 billion.  Around Thanksgiving, another $20 billion.  This time the government will up their stake to 25-40% by converting their preferred shares of the company to equity and injecting them with new capital, according to press reports describing the latest rescue plan.

Friday, officials were denying a plan to nationalize the banks.  When the government steps in and buys 40% of Citigroup, while the majority of ownership does still reside among public shareholders, it certainly does smack of nationalization.  Semantics aren’t the point here, though.  Call it what you want, they’re saving Citigroup by taking a significantly larger stake.

Good for Citigroup… I guess.  The stock is up but massive equity dilution isn’t typically positive for stock price.  Since the risk here is insolvency, maybe diluted and alive is better.  Citigroup was significantly underwater by the tangible equity ratio and was sure to fail the “stress tests” planned this week by the Fed.  Frankly, the fact that they couldn’t wait till the stress test at Citigroup before injecting them is pretty ominous.  It suggests Citi was going under today or tomorrow if they didn’t do something immediately.

What about Wells Fargo (WFC), Bank of America (BAC) and Capital One Financial (COF)?  Are they planning to save them too?  They’re probably going to need to as every time they’ve selected an institution to save, it’s increased the pressure on the unsaved.  When the Fed backstops institutions they theoretically removing the trading risk for counterparties.  Why trade with a bank with a spiraling stock price and no government backing when you can trade with one that’s protected?  And there’s the rub.  Saving one highlights the risk of the others.  The pressure will resume somewhere else.

Selective nationalization creates a list of broken banks on life support – comatose, breathing, but struggling to hold on.  By omission, though, it also creates a list of sick banks still to be broken.  Plug one hole and you increase pressure on the rest of the structure.  Any relief from the Citigroup action is likely to be short-term.  This will be a very tense week for financials, despite the government’s attempts to stabilize the system, as the stress tests are likely to point to weakness in financial controls at the banks – the problem all the way down has been an underestimation of portfolio risk.  With these institutions able to rely on the government to step in and save them, its likely that portfolio risk still exists as unwinding positions is likely near impossible.  Prior plans floated have included the government overpaying for underwater assets – why would you sell an underwater asset if you knew the government might pay you more than its worth?  You wouldn’t.  They didn’t.

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