Posts Tagged ‘Citigroup’

The Out­rage Makes Them Larger

Recently, much has been writ­ten about “Wall Street” bonuses. Almost all of those arti­cles men­tion the same two things: (1) pop­ulist and gov­ern­ment sen­ti­ment against the bonuses, and (2) the com­po­si­tion of the bonuses towards long-​term, restricted stock and away from cash. At least some of the drive towards a more stock-​heavy com­po­si­tion seems to be management’s attempt to appease the gov­ern­ment and the pub­lic. In this post, we argue that such moves are need­lessly costly, which means inef­fi­cient and larger than need be.¹

In a pre­vi­ous post, Gov­ern­ment Whin­ing and Bailout Fees, we dis­cussed the out­rage and men­tioned that cit­i­zens have a right to be angry – at the gov­ern­ment. In this post, we ana­lyze the reported com­po­si­tion of many of bonuses. In par­tic­u­lar, we think the insis­tence on long-​term, restricted stock grants is inef­fi­cient for sev­eral rea­sons that we dis­cuss below.

How­ever, before con­tin­u­ing, it is worth re-​mentioning that much of the con­tro­versy could be elim­i­nated by elim­i­nat­ing pro­pri­etary trad­ing at insured insti­tu­tions. As we have repeat­edly writ­ten, we have noth­ing against pro­pri­etary trad­ing or traders, but see no rea­son why we or other tax-​payers should sub­si­dize trad­ing losses. Note, too, that there are other good rea­sons to elim­i­nate such activ­i­ties at insured insti­tu­tions, includ­ing the fact that they diverts man­age­r­ial atten­tion away from (bor­ing and mun­dane) every­day activ­i­ties of run­ning com­mer­cial banks. We know that at the mar­gin, there’s not much of a dif­fer­ence between a bank’s trea­sury (asset-​liability) man­age­ment and cer­tain kinds of prop trad­ing, but we’d pre­fer that reg­u­la­tors keep a nar­rower focus. Finally, to get, in a sin­gle edi­tion of The Wall Street Jour­nal, Thomas Frank, Jonathan Macey, and James B. Stewart to agree with us is mind-​boggling. It indi­cates the abject per­ver­sity of the sta­tus quo.

Now, hav­ing said that, we hope that every­one receiv­ing the much-​discussed bonuses get max­i­mum enjoy­ment and sat­is­fac­tion from them. We cer­tainly don’t blame any­one for try­ing to max­i­mum his or her com­pen­sa­tion in an attempt to max­i­mize their sat­is­fac­tion, their family’s sat­is­fac­tion and well-​being, and their con­tri­bu­tion to the less for­tu­nate. The prob­lem is that there are likely cheaper ways to pro­vide the same level of sat­is­fac­tion and reward.

Aside: note that for the remain­der of this post, we’ll use the word “expected,” as in “expected com­pen­sa­tion,” in a very loose, non-​mathematical way. That’s because we are rather pedan­tic and like to empha­size the dif­fer­ence between uncer­tainty and risk. Like oth­ers, we define risk as mea­sur­able uncer­tainty, and that means that risk is a spe­cial type of uncer­tainty or unknow­ing can be (appro­pri­ately) described as a prob­a­bil­ity dis­tri­b­u­tion. Not all prob­a­bil­ity dis­tri­b­u­tions have means or expected val­ues, and that seems to be the case in finan­cial mar­kets. So, try­ing to cal­cu­late one’s expected bonus as a func­tion of mar­ket per­for­mance might not be tech­ni­cally fea­si­ble if the dis­tri­b­u­tion of returns is unknown or its moments don’t exist.²

So what’s wrong with bonuses in the form of long-​term, restricted stock?

Well, they are long-​term so they defer con­sump­tion, they are restricted so they’re are expen­sive to con­vert into con­sump­tion, and they in sotck so they are risky (uncer­tain) because they are only very weakly tied to an individual’s performance.

Delayed Grat­i­fi­ca­tion:

Are there good rea­sons for long-​term com­pen­sa­tion schemes? Yes, there are.

When employ­ees take actions or make deci­sions that have long-​term impli­ca­tions, then sig­nals from mul­ti­ple peri­ods can be used to infer whether the employee behaved appro­pri­ately – back when the the deci­sion was made.

Gen­er­ally, the use of mul­ti­ple sig­nals improves the pre­ci­sion of the infer­ence, and that means that less risk is imposed on the employee.³ For risk-​averse employ­ees, that means a lower risk pre­mium is required to ensure his or her par­tic­i­pa­tion, which means a smaller expected bonus is required.⁴ So, the key to reward­ing long-​term per­for­mance is clas­si­fy­ing cur­rent period results into the time peri­ods when deci­sions were made so that one can make bet­ter infer­ences about the deci­sions made in a prior period. It’s not as easy as it sound, but it is pos­si­ble to do.

So, yes, most traders that make long-​term bets should be rewarded on long-​term per­for­mance, and fea­tures like claw backs should be used, but in the spe­cific way that we wrote about in Claw­backs: the Good, the Bad, and the Ugly and Incen­tives at UBS and in Gen­eral.

How­ever, requir­ing some­one to wait five years to receive stock in a mega-​corporation is not the same thing. That’s because:

1. Five years is arbi­trary, and may have lit­tle to do with the length of the employee’s invest­ment deci­sion. More­over, it is a long-​time to wait for a pay-​off.
2. If we’ve learned noth­ing else dur­ing the past few years, we have learned that, in gen­eral, share prices are very volatile, which means that employ­ees who must wait five years for their reward must bear a sub­stan­tial amount of risk.
3. Other than pos­si­bly a few senior exec­u­tives, no sin­gle employee has very much antic­i­pated or expected influ­ence on share price in five years. Ex post they may have, but not ex ante.

So, it seems rea­son­able to con­clude that impa­tient, risk-​averse employ­ees would sub­stan­tially dis­count the expected value of such stock grants.⁵ That means that all things equal, it means that if they can, employ­ees will demand larger bonus grants to com­pen­sate for the delayed grat­i­fi­ca­tion and the risk.

Restric­tive:

We imag­ine that the only peo­ple who pre­fer that bonuses be in the form of restricted stock are folks who aren’t get­ting them and the envi­ous types: please see The Chil­dren who Have Eaten their Cake…

Usu­ally, there are ways to bor­row against such grants and/​or hedge the value of such grants, but not all firms per­mit such actions. More­over, they’re not cheap and they can be time-​consuming.

That means that employ­ees will bear costs of con­vert­ing the awards to nearer-​term con­sump­tion and, if pos­si­ble, will demand larger bonuses to cover those costs.

Risky and Uninformative:

For some reason,many folks (and politi­cians) believe that when employ­ees own shares, includ­ing restricted stock, incen­tives are some­how mag­i­cally aligned – kind of like Lucky Charms.

How­ever, except for pos­si­bly a small hand­ful of very senior man­agers, that’s very silly. Con­sider that Bank of Amer­ica has nearly 300,000 employ­ees, Cit­i­Group has about the same, and even smaller firms like Gold­man Sachs have more than 30,000. So, the effect of any sin­gle employee is usu­ally very small. (More­over, the pre­dicted effect is usu­ally very small. In fact, when it is large, it is often due to the firm’s fran­chise and rep­u­ta­tion and not that par­tic­u­lar person’s actions.)

Do note that attempt­ing to link the effects of a par­tic­u­lar action, deci­sion, invest­ment or trade to share price today or any point in the future is extremely dif­fi­cult. (Maybe not in finance class, but it is in real life.)

Just as impor­tantly, and as we men­tioned above, even if it can be done (in expec­ta­tion) the firm’s stock price is a par­tic­u­larly noisy mea­sure of a par­tic­u­larly person’s per­for­mance. So, it’s quite pos­si­ble to con­clude that employ­ees will ignore the impli­ca­tion of their deci­sion of share prices, which is com­pletely ratio­nal, and do what’s best for them­selves. That very much reminds us of that quote of Huck­le­berry Finn that we always used when we taught: “Well, then, says I, what’s the use you learn­ing to do right when it’s trou­ble­some to do right and ain’t no trou­ble to do wrong, and the wages is just the same?”

For more on this gen­eral topic, we refer inter­ested read­ers to our essay in the Fal­lacies sec­tion of the web site: One Per­for­mance Mea­sure to Rule Them All.

For more on this topic as it per­tains to trad­ing, we encour­age vis­i­tors to read the last half of the above-​mentioned, The Chil­dren who Have Eaten their Cake…

In sum, we argue that (1) the long-​term nature that delays con­sump­tion, (2) the restricted nature that is costly to bypass, and (3) risky nature fur­ther reduces the value (think in terms of expected util­ity or cer­tainty equiv­a­lent) make such bonuses worth sub­stan­tially less than their face value. If employ­ees have any bar­gain­ing or nego­ti­at­ing power, firms will have to increase the stated value of the bonuses to sat­isfy them.

Those extra costs would be worth bear­ing if they aligned incen­tives, but unless you, dear reader, believes in magic, there is no rea­son to believe that any future actions by those employ­ees will be coöper­a­tive in nature.

So, it seems that long-​term, restricted stock awards are inef­fi­cient ways to moti­vate employees.

We’ll likely proof­read this post and edit it in the near future.

P.S. Our New Year’s res­o­lu­tion is to write more about finan­cial mat­ters, the indus­try and the cri­sis than we did dur­ing last half of 2009. Last fall’s drought occurred for a vari­ety of good rea­sons, but two related ones are worth men­tion­ing: (1) while many of our posts tend to be long, we hate being repet­i­tive, and in our mind there was lit­tle new to say, and (2) with lit­tle new to say, we found many of the events and pro­ceed­ing to be quite bor­ing. For writ­ing blog posts, “bor­ing” means too many ref­er­ences to old mate­r­ial – like above – but we’ll try to write more in 2010.

Copy­right © 2010 Spero Consulting

Foot­notes:

Given the past two days’ front page head­lines in the The Wall Street Jour­nal, it seems that banks are doing a lot of brac­ing. Monday’s head­line announced that Banks Brace for Bonus Fury, and today’s head­line announces that Banks Brace for Bailout Fee.

The first arti­cle notes of com­plaints by the pub­lic and gov­ern­ment offi­cials about bonuses paid for 2009 ‘results.’ The sec­ond arti­cle describes a likely attempt by fed­eral offi­cials to, in some sense, mon­e­tize those com­plaints by levy­ing new fees onto banks. (Soon, we’ll soon pub­lish a related post regard­ing the inef­fi­ciency of many of the bonus plans.)

There is some­thing dis­turb­ing about large bonuses at sev­eral, if not all, of the firms that are fre­quently men­tioned in the press. That’s because firms like B of A (and its sub­sidiary Mer­rill Lynch) and many oth­ers did not gen­er­ate last year’s gains and prof­its on their own. They could not have gen­er­ated those prof­its on their own. So, regard­less of their repay­ment of the TARP funds, it doesn’t seem that all those prof­its should be theirs to use or dis­trib­ute in what­ever man­ner that they choose.

Thus, the pub­lic has a right to com­plain about the pay­ment of the sub­si­dized bonuses, but don’t blame the employ­ees at the firms; instead, blame the gov­ern­ment for not hav­ing thought through the impli­ca­tions of its guar­an­tees and promises when it made the invest­ments. It was another case of very short-​term think­ing by our elected and appointed officials.

To be sure, it is highly likely that many dili­gent and earnest work­ers per­formed well and earned their bonuses, but for many others, profits were rec­og­nized only because the fed­eral government’s guar­an­tee kept many of their firm viable and/​or credit-​worthy.

It wasn’t the pre­ferred stock invest­ment that kept the firms alive when their counter-​parties and oth­ers had lost faith nor the sub­se­quent increase of some silly cap­i­tal ratio. You seen cap­i­tals ratio et. al., are non sequiturs dur­ing a liq­uid­ity cri­sis. If the firm doesn’t have cash and can’t raise it because no one will buy its hold­ings or invest in it, its can’t sell the cap­i­tal ratio or use it for collateral.

It was the government’s guar­an­tee to each firm that was deemed “too big to fail” that saved it one of them and allowed their trad­ing part­ners to prosper.

Those guar­an­tees made the gov­ern­ment the de facto resid­ual claimant despite its small, for­mal own­er­ship stake (in pre­ferred stock for the most part).¹

The prob­lem is that the gov­ern­ment didn’t do a very good job of nego­ti­at­ing the terms of those guarantees.

At the time of the TARP invest­ments and promises, our pub­lic ser­vants pan­icked. They didn’t take the time to demand covenants and restric­tions on the future use of funds nor did they charge an ade­quate fee for sav­ing the insti­tu­tions.² As we wrote at the time, we thought the fees should include many rolling heads and the elim­i­na­tion of much com­mon equity.

Given that, it’s a lit­tle bit ironic and quite a bit silly for gov­ern­ment offi­cials to com­plain about cur­rent com­pen­sa­tion lev­els and 2009 bonuses. If the gov­ern­ment wanted to do some­thing about bonuses it should have restricted them when it injected the cash and guar­an­teed the firms’ sur­vival.³ It shouldn’t whine now or attempt to apply retroac­tive fees although charg­ing sub­stan­tial fees for the con­tin­ued sub­si­diza­tion is okay with us.

A long aside: at first glance, reg­u­lar read­ers may regard our opin­ion as incon­sis­tent with our sup­port last sum­mer for Andrew Hall in his dis­pute with Citigroup, but it’s not. See Prop Trad­ing and Pay at Banks.

Our points then were:

1. The gov­ern­ment and reg­u­la­tors had no author­ity to abro­gate con­tracts, includ­ing pay con­tracts. So, Citi should give him his due.
2. Bank­ruptcy does pro­vide the oppor­tu­nity to rene­go­ti­ate con­tracts, but the gov­ern­ment wouldn’t let events run their course. Arbi­trar­ily abro­gat­ing (or dishonoring) contracts is uncon­sti­tu­tional. More impor­tantly, main­tain­ing the dis­ci­pline to uphold seem­ingly unpop­u­lar con­tracts is cen­tral to main­tain­ing the Rule of Law. It dis­tin­guishes the U.S. from many other nations, and that col­lec­tive self-​restraint makes this a great (and gen­er­ally pre­dictable) nation.
3. Mr. Hall and all other pro­pri­etary traders should find new, unreg­u­lated places of employ­ment, where they can reap the rewards of their com­bined clev­er­ness and efforts but also bear the risks of fail­ure. (It seems to have worked-​out well for him, and we sus­pect would work out bet­ter for most traders.) See our post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We pre­sume that Mr. Hall and Phi­bro would have made those gains with or with­out Citi; so, the gov­ern­ment sav­ing Cit­i­group had lit­tle effect on his trad­ing strate­gies. (Who knows? His gains may have been larger with­out Citi and with more capital.)

Why do we whine about about our pub­lic ser­vants whin­ing and try­ing to impose fees? Well for two rea­sons: (1) it’s annoy­ing to her them com­plain about com­pletely pre­dictable behav­ior that they induced and (2) the cur­rent sit­u­a­tion is no dif­fer­ent than the sit­u­a­tions that the gov­ern­ment cre­ated at Fan­nie and Fred­die when those two thin­gies were pay­ing large bonuses for “per­for­mance” that was wholly-​subsidized by the gov­ern­ment. That cre­ated and/​or exac­er­bated moral haz­ard prob­lems then and will now, too.

In con­clu­sion, note that we’re not resent­ful or envi­ous of any­one get­ting a large bonus, and we hope that folks enjoy them, but we do blame the bureau­crats at the Trea­sury and the Fed for not con­sid­er­ing this out­come in the fall of 2008 and early 2009. Fur­ther­more, we don’t see the pro­posed appli­ca­tion of an arbi­trary, ex post tax as any­thing other than vin­dic­tive­ness or the appease­ment of the pop­ulist mob. Either motive should be beneath our fed­eral officials.

Finally, note that we’ve com­plained about sim­i­lar gov­ern­ment actions in the past. For exam­ple, see The Chil­dren who Have Eaten their Cake… and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary and Dan­ger­ous.

The Wall Street Jour­nal has an excel­lent edi­to­r­ial in today’s edi­tion: The $100 Mil­lion Banker.

Why do we say the edi­to­r­ial is “excel­lent?” For the usual rea­son; it is nearly iden­ti­cal to what we’ve writ­ten in the past: give Mr. Hall his money and ban prop trad­ing at reg­u­lated banks.

If you missed those posts, see these two recent ones: Prop Trad­ing and Pay at Banks and The Chil­dren Who Have Eaten Their Cake… Those two pro­vide links to many related ones, too. The lat­ter one promises an addi­tional new post about the dis­pute, but we’ve not had time to fin­ish it, and it won’t hap­pen today.

Yes, reg­u­lar read­ers will notice that this is a very short post for us. While we’re nearly sur­rounded by a tem­per­ate rain for­est, if the lawn is not mowed today, the for­est will be that much closer tomor­row. That what hap­pens when it rains and shine nearly every day for sev­eral weeks in the mid­dle of the sum­mer. (And, yes, dear reader, like Tol­stoy, we enjoy toil­ing in the field with the (other) peasants.)

We hate it when one of our favorite quotes is used against us, but that is the nature of our queen and chair­man. (Although she does it in a good-​natured, light-​hearted, and humor­ous way, there is steely resolve in her teas­ing words.)

Actu­ally, she didn’t use the exact quote; instead, she updated it and made it more rel­e­vant to the sit­u­a­tion at hand. That made it all the more painful. Her ver­sion with ref­er­ence to today’s lunch, or shall we say the absence of lunch was: “The chil­dren who have eaten their Pani­nis are the nat­ural ene­mies of the chil­dren who have their (left-​over) pizza.”

That’s not very dif­fer­ent than Jeremy Bentham’s orig­i­nal quote from 1844. “The chil­dren who have eaten their cake are the nat­ural ene­mies of the chil­dren who have theirs.” In some sense, she just Ital­i­cized it.

By the way, we think Bentham’s one-​line quote, and the sur­round­ing text, which we show below, per­fectly describes the pet­ti­ness and envy that is exem­pli­fied by the Congress’s behav­ior regard­ing the AIG bonuses in the Spring, the cre­ation of the Obama administration’s silly “pay czar” posi­tion, and the recent pub­lic­ity regard­ing Andrew Hall’s $100 mil­lion pay dis­pute with Cit­i­group. Envy and power – much like in the Russ­ian Rev­o­lu­tion and many other sim­i­lar set­tings – are a ter­ri­ble combination.

Very shortly we hope to pub­lish our say on ways to resolve the dis­pute between Mr. Hall and Cit­i­group. It is a very inter­est­ing prob­lem: like a three-​person game of chicken. In fact, we were gath­er­ing our thoughts by the pool, when we decided to ven­ture into the house for her left-​over pizza. Unlike our gov­ern­ment or the Bol­she­viks, we had no chance to behave opportunistically.

How­ever, rather than dis­cussing Mr. Hall’s par­tic­u­larly prob­lem, which involves the government’s (and pos­si­bly Citi’s) ex post oppor­tunis­tic behav­ior, we’d pre­fer to men­tion a quite gen­eral and viable solu­tion. It is so viable, that it is pos­si­ble that trad­ing firms have already imple­mented sim­i­lar schemes, but we doubt it.

We have in mind very for­mal and objec­tive shar­ing rules for daily trad­ing gains and losses com­bined with other objec­tive, long-​term per­for­mance (and risk) mea­sures. We think it would be worth­while to have cre­ate indi­vid­ual trust accounts, admin­is­tered by an inde­pen­dent third party, which set­tle each trad­ing day to accu­mu­late a trader’s share of his pro­pri­etary gains and losses. A sim­ple lin­ear con­tract that pays a per­cent­age of gains and the same per­cent­age of losses could work, but any­thing cal­cu­la­ble and under­stand­able would work, also. Each day, the account would set­tle – like any other daily set­tle­ment or clear­ing­house agreement.

Note that noth­ing in the pre­vi­ous para­graph pre­cludes such a con­tract from being long-​term in nature, nor does such an arrange­ment nec­es­sar­ily per­mit the trader to with­draw the funds at will (although like many 401K plans, firms could per­mit traders to bor­row against the accrued bal­ances at some mar­gin or hair­cut). More­over, noth­ing men­tioned above would pre­clude the use of claw­backs or other long-​term fea­tures – as long as they are objec­tive, and con­tractible in nature, and (there­fore) administer-​able by a third party.

The non-​opportunistic admin­is­tra­tion of the trust by a third party is the key. It elim­i­nates the pos­si­bly sub­jec­tive, capri­cious, and arbi­trary types of arrange­ments that we dis­cussed in Claw­backs: the Good, the Bad, and the Ugly. (We also men­tioned them in Incen­tives at UBS and in Gen­eral and Risk Con­cen­tra­tion, Con­cen­trated Losses and Incen­tives and a host of other posts.)

We’ll likely write more in the future on this type of arrange­ment. In our mind, if senior man­agers of trad­ing groups can’t spec­ify the major pro­vi­sions of such con­tracts, then they prob­a­bly don’t under­stand what their traders are doing and prob­a­bly shouldn’t be senior man­agers. So, if direc­tors forced such arrange­ments into trad­ing areas, there is a chance that over­all man­age­ment and con­trol would be improved. (After writ­ing that, we real­ize how hope­lessly naïve it reads.)

Of course, the above sug­ges­tions apply only to pro­pri­etary trad­ing, not for hedg­ing or trad­ing with cus­tomers. Also, because we – as a tax-​payer – have absolutely no desire to sub­si­dize prop traders – we get none of their gains – we think prop trad­ing at insured insti­tu­tions should be banned. More­over, we cer­tainly believe that the gov­ern­ment has the right to limit pay at insured insti­tu­tions, but those lim­i­ta­tions should be known and spec­i­fied before the con­tracts are signed, not after­wards as in the AIG exec­u­tives’ cases or pos­si­bly in Mr. Hall’s case.

Finally, if you found this inter­est­ing, you may like these related analy­ses: Incen­tives and the Finan­cial Cri­sis and Busi­ness Schools, Incen­tives, Uncer­tainty, and the Finan­cial Cri­sis.

There is an arti­cle in today’s edi­tion of The Wall Street Jour­nal that attempts to frame Citi’s pay “dilemma” with trader Andrew Hall of its Phi­bro unit as some type of Gor­dian Knot: Citi in $100 Mil­lion Pay Clash. It’s not.

It seems that Citi­corp will legally owe Mr. Hall about $100 mil­lion for his com­pen­sa­tion in 2009, but Citi’s senior man­agers are con­cerned about the polit­i­cal ram­i­fi­ca­tions of pay­ing such a large amount. The last time we checked, Citi had taken about $45,000,000,000 – yes, $45 bil­lion – from wealthy, middle-​class, and poor tax­pay­ers, and those tax­pay­ers had guar­an­teed losses of a few hun­dred bil­lion more.

We sup­pose that folks at Citi are con­cerned that the Obama admin­is­tra­tion and the pop­ulists in Con­gress will attempt to penal­ize the firm – or pos­si­ble incrim­i­nate the man­age­ment – for mak­ing such large com­pen­sa­tion pay­ments. (Note: since at least the found­ing of the FDIC in 1933, Con­gress has had the leg­isla­tive power to have ban such con­tracts, but has cho­sen not to do so.)

We’ve writ­ten a few times about the impor­tance of the rule of law, and it’s quite shame­ful that many of our elected offi­cials and rep­re­sen­ta­tives place such lit­tle value on it. (These are exactly the indi­vid­u­als that our Found­ing Fathers tried to pro­tect against.) It’s almost as shame­ful as Mr. Obama stu­pidly insert­ing him­self into the Gates/​Cambridge Police mess; he does need to learn to shut-​up.

We wrote about the AIG pay con­tro­versy in It Truly Is Dis­grace­ful! and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary (and Dan­ger­ous), and we don’t see this emerg­ing con­tro­versy as being any different.

That being said, we do believe that prop trad­ing should be elim­i­nated at insured insti­tu­tions, includ­ing Citi­corp, because we see no rea­son that tax­pay­ers, includ­ing our­selves, should sub­si­dize their risk-​taking. We first rec­om­mended it in Octo­ber in the aptly titled, Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions, and men­tioned it many time since then, includ­ing our recent post, Paul Vol­cker Has It Right.

It seems that Mr. Hall earned his huge com­pen­sa­tion award because he and his trad­ing group gam­bled and won big. How­ever, it was quite pos­si­ble for him to have lost (and lost big). That would have increased the size of Citi’s losses and required addi­tional tax­payer subsidization.

We don’t know Mr. Hall, but we do wish him every suc­cess in the world. We just have absolutely no desire to back­stop him (and it’s not just his pen­chant for mod­ern art).

We pre­fer that he work for a trad­ing unit of a non-​insured insti­tu­tion or run a hedge fund so that we don’t have to sup­port him if he fails. In fact, a very short arti­cle in the Journal’s Heard on the Street sec­tion, Hedge Funds’ Pro­pri­etary Advan­tage, describes how many hedge funds are cur­rently doing quite well (after many recent dis­as­ters last year). That’s the nature of the busi­ness. Let those will­ing to take the risks, reap the rewards AND bear the con­se­quences of fail­ure. (Is it too really much to ask?)

Per­haps Mr. Hall would like to pur­chase the Phi­bro unit from Citi and accept those same risks and rewards that other fund oper­a­tors face. It seems that clos­ing the sale before the end of the cal­en­dar year would (or could) be a grand out­come for both Mr. Hall and Citi. We think that ban­ning prop trad­ing at insured insti­tu­tions as of Jan­u­ary 1, 2010, would go a long way towards slic­ing through sim­i­lar knotty sit­u­a­tions at other banks.

One final note: in the tra­di­tion of horrendously-​arranged gov­ern­ment web sites, see the above-​mentioned FDIC site. It’s ugly and busy and has no focus, and it’s just what we expect from our bureau­cracy. Does the reader have any higher expec­ta­tions? Be honest.

How Much Have They “Gained” From Becom­ing Worth Less?

Since the begin­ning of April, when many large banks reported unex­pected (or unex­pect­edly large) first-​quarter prof­its, we’ve won­dered what per­cent­age of those prof­its could be attrib­uted to the account­ing rule that lets them rec­og­nize a gain because their own lia­bil­i­ties have become worth less. (We think “worth less” is the cor­rect form, but for the extreme cases, it should indeed be “worthless.”)

We wrote about this issue of rec­og­niz­ing gains from losses in mid-​December in our post Mark­ing Debt to “Mar­ket” or Addi­tion Through Sub­trac­tion. Basi­cally, if cred­i­tors don’t want your bonds, the value of the secu­ri­ties decrease, and yields (and credit spreads) increase. Firms are allowed to rec­og­nize the fact that oth­ers view them as worth less as an unre­al­ized gain to share­hold­ers. (“Unre­al­ized” means that no trans­ac­tion occurred between the firm and its cred­i­tors.) It doesn’t seem to be a very com­pelling argu­ment because as cred­it­wor­thi­ness declines, equity val­ues tend to do so, also. (Ask Citigroup.)

We wish we had more time, or at least more patience, to scan the banks’ first-​quarter finan­cial state­ments on their web sites, but based upon the sites we vis­ited, it doesn’t seem that those gains (from becom­ing riskier and worth less) are some­thing that banks want to pub­li­cize, sep­a­rately iden­tify, or explain. (You can’t blame them for that.)

In our brief on-​line search this morn­ing, we found this blog post, Mark-to-market’s strange account­ing ben­e­fits for Citi and BofA, which notes that Citigroup’s gain – or at least part of the gain – was $2.5 bil­lion but its over­all net profit was only $1.6 bil­lion, and Bank of America’s net gain because it was worth less was about half of its net profit of $4.2 bil­lion. In the pre­vi­ous sen­tence, we wrote the qual­i­fier – between the dashes – to empha­size that it’s pos­si­ble that such gains were actu­ally big­ger but may have been split among dif­fer­ent seg­ments or cat­e­gories. We looked at another bank’s first-​quarter income state­ment, and it showed the com­bined, net, unre­al­ized, gain on assets and lia­bil­i­ties of about $1.5 bil­lion; so, it’s con­ceiv­able that it actu­ally rec­og­nized a loss on assets of sev­eral bil­lion and a gain on re-​valuing/​devaluing lia­bil­i­ties of a larger amount, which nets to the $1.5 bil­lion or so. We ask: if that were the case, would the dear reader think bet­ter or worse of that par­tic­u­lar bank?

Our hunch, based upon these few obser­va­tions, is that bank stock prices would have decreased if these unre­al­ized gains would have been reported explic­itly for what they were/​are. Gen­er­ally, we’re agnos­tic about the ben­e­fits of trans­parency; how­ever, this is one time when we wish that there was a bit more of it. (See our post, Gos­samery Argu­ments for Trans­parency and Our Reply, from last Novem­ber for why more trans­parency isn’t nec­es­sar­ily better.)

The Irrel­e­vance of Book Equity and Cap­i­tal Ratios

Last month we wrote March Mad­ness: New Bank Cap­i­tal Require­ments. In that, we stated: “We’ve always thought that such require­ments were stu­pid and pro­vided a false sense of secu­rity: kind of like duck­ing and cov­er­ing under one’s school desk as prac­tice and prepa­ra­tion for a nuclear explosion.”

We also pro­vided an exam­ple from an old merger of two rust belt firms. At the time of the merger, the firms had com­bined book val­ues of $2.0 bil­lion ($2,000 mil­lion) but com­bined mar­ket val­ues of about $300 mil­lion. At its the­o­ret­i­cal best, book value rep­re­sents net expected future ben­e­fits from past trans­ac­tions or events, whereas mar­ket value rep­re­sents net expected future ben­e­fits from all trans­ac­tions and events – both past and antic­i­pated. In the rust-​belt merger exam­ple, at the time, equity investors had con­cluded that the future would be bleak, and it turned out to be, but also at the time, no loan covenants were breached.

We think that’s worth restat­ing because on Mon­day, Bank of Amer­ica reported com­mon share­hold­ers’ equity of $166 bil­lion, yet finance​.google​.com reports that the mar­ket value of com­mon stock was about $50 bil­lion. Now, exactly how rel­e­vant is the book value of $166 bil­lion when investors value the firm at less than one-​third of it? We’d say, “not very.”

Think about it. Do you care if your house has a net book value of $166,000 if its net mar­ket value is $50,000. Or, ignor­ing tax-​planning impli­ca­tions, do you care if your lever­aged port­fo­lio has a book value of $166,000 if it can be liq­ui­dated for $50,000? Would you make deci­sions based upon the actual net equity of $50,000 or the reported net equity of $166,000? What do you think that, say, poten­tial cred­i­tors would con­sider when offer­ing financ­ing? More­over, what would you want them to con­sider if those cred­i­tors were act­ing as agents for you? There may be reg­u­la­tory impli­ca­tions to the book val­ues, but it seems that investors have con­cluded that those reg­u­la­tions (and all of the sub­si­dies) haven’t pro­vided enough sta­bil­ity or value to secure their resid­ual interests.

Also, real­ize that B of A’s net book value is greater because its lia­bil­i­ties are worth less than they were, which is not quite com­pletely worth­less. The prices for claims on the gross assets have declined. These are the silly, unre­al­ized account­ing gains are shown as result­ing from increases in credit spreads. In B of A’s case, they rec­og­nized at least $2.2 bil­lion of them in the first quar­ter although it was prob­a­bly more. (We wrote about this topic in Decem­ber in Mark­ing Debt to “Mar­ket” or Addi­tion Through Sub­trac­tion. 

By the way, and of course, B of A is not alone with its imbal­ance between its lower net mar­ket value and its much higher net account­ing value. In fact, Citi’s ratio of market-​to-​book equity ratio is sub­stan­tially smaller. And remem­ber, that’s despite the hun­dreds of bil­lions of dol­lars of guar­an­tees made by the U.S. gov­ern­ment on Citigroup’s behalf.

We chuck­led when we saw this head­line in The Wall Street Jour­nal today, Jan­u­ary 15: Fed Offi­cials Say Ail­ing Banks Require More U.S. Funds.

That’s not really news, and – by the way – it’s tau­to­log­i­cal or true by def­i­n­i­tion. (Uh, oth­er­wise, they wouldn’t be ail­ing now would they, precious.)

Any­way, our point is always the same – we’re con­sis­tent that way. Just because they need the money, doesn’t mean that they deserve the money nor does it mean that they’ll spend it wisely.

In that way, they’re not much dif­fer­ent the the home­less alco­holics who beg for drink­ing money on the Roberto Clemente bridge in the city of Pitts­burgh, and pre­sum­ably – this is just a wild hunch – in other cities around the coun­try, too.

Now, we know that some drug addicts get monthly Social Secu­rity checks from the fed­eral gov­ern­ment because their drug addic­tion tech­ni­cally – or, at least, bureau­crat­i­cally – dis­ables them, but we don’t think that usage is wise gov­ern­men­tal pol­icy, either. Maybe it’s just our nar­row way of think­ing, but such poli­cies not only sub­si­dize but also seem to con­done such unde­sir­able, anti-​social behav­ior, and we, as a soci­ety, end-​up with more of the dys­nfunc­tion­al­ity that we should be try­ing to eliminate.

The only com­pel­ing argu­ment that we’ve ever heard for such sub­si­diza­tion was pre­sented by the aptly named, Alfie Doolit­tle, Eliza’s father, in My Fair Lady. His was a strictly util­i­tar­ian argu­ment. Mr. Doolit­tle didn’t really deserve the £5 he was ask­ing for (her). In his own words, he was unde­serv­ing and planned to con­tinue to be unde­serv­ing, but he’d cer­tainly enjoy spend­ing it on a spree for he and his mis­sus; so, in that sense, the pay­ment would be used to max­i­mize soci­etal wel­fare and cre­ate jobs for those serv­ing him.

We don’t see the valid­ity of that argu­ment in the government’s response to the cur­rent finan­cial cri­sis, and it seems that many other mem­bers of the middle-​class feel the same way.

By the way, in an arti­cle yes­ter­day, U.S. Seeks Rest of Bailout Cash, the reporters Deb­o­rah Solomon and Damian Paletta wrote: “Con­gress rejected Trea­sury Sec­re­tary Henry Paulson’s ini­tial request, send­ing mar­kets tum­bling. A sec­ond ver­sion of the law passed sev­eral days later, allow­ing Trea­sury imme­di­ate access to $350 billion.”

Per­haps those two slept through the wealth destruc­tion that fol­lowed pas­sage of TARP, as they make no men­tion of that drop in equity val­ues. The DJIA was at 10,831 on Sep­tem­ber 30; so, talk about rewrit­ing his­tory! More pre­cisely, talk about an extremely weak argu­ment to waste more of our money!

Per­haps if the ail­ing banks and their reg­u­la­tors were a bit more straight­for­ward and bit more like Alfie Doolit­tle, we’d per­son­ally be a bit more sym­pa­thetic. Until then, we’ll point read­ers to our other posts, includ­ing the last few (What Is Cit­i­group Worth? and When Is Enough Enough?) and our entry from three months ago when we first called for the nation­al­iza­tion of the weak­est banks as a les­son to the remain­ing healthy ones: It’s Time!

So, we con­clude by ask­ing rhetor­i­cally: why sub­si­dize irre­spon­si­ble, anti-​social behav­ior, regard­less of the recip­i­ents’ hygiene, con­nec­tions, or cronies, espe­cially when – unlike Alfie – it and they are not the least bit amusing?

The Wall Street Jour­nal has an edi­to­r­ial in today’s paper – Jan­u­ary 14 – that seems to be ripped from our head­lines: it calls for the dis­mem­ber­ment of Cit­i­group, and it implies that Citi has lost its right to exist. (See When Is Enough Enough?, for exam­ple, or any of our calls to nation­al­ize it.)

As we’ve seen in var­i­ous news reports, Cit­i­group has lost about $30,000,000,000 or so in the last five quar­ters and has received about $45,000,000,000 in TARP funds, and the fed­eral gov­ern­ment has guar­an­teed another $250,000,000,000 or so of its debts.

And yet, and yet, Citigroup’s stock price is about $5, which gives it a mar­ket value, accord­ing to Google Finance of about $32 bil­lion. That’s less than 10% of its share price two years ago and about 20% of its share price this time last year.

As a point of com­par­i­son, if the fed­eral gov­ern­ment gave us $45 bil­lion, we would be worth $45 bil­lion. (Well, almost $45 bil­lion, but a lot closer to $45 bil­lion than $32 bil­lion. And, yes, we know there is a dif­fer­ence between the government’s pre­ferred invest­ment and mar­ket value of the com­mon shares.)

Hmmm, with­out both­er­ing to check the tax impli­ca­tions, let’s gross-​up the loss of about $30,000,000,000 to the $45 bil­lion. That means that the gov­ern­ment has sub­si­dized all of the rec­og­nized losses to date.

So, despite the guar­an­tee of debt, which could be val­ued the same way that banks esti­mate val­ues of their insured deposits, and despite the addi­tional deposit insur­ance cov­er­age, etc., soci­ety and the world econ­omy think that Cit­i­group isn’t worth a whole lot.¹

Dili­gent, and younger read­ers with good mem­o­ries, may recall that as far back as Sep­tem­ber we sep­a­rated the mort­gage fiasco from the larger, and far more seri­ous, liq­uid­ity cri­sis in con­fi­dence. (Here’s an entry from early Octo­ber: Even A Per­fect Bailout Will Fail.)

We cite Cit­i­group as prima facie evi­dence of that dis­tinc­tion. Based upon equity val­ues – despite the government’s mas­sive injec­tion of funds and its guar­an­tees – we’d say that the mort­gage fiasco has informed investors through­out this coun­try and across the world that’s Citi’s man­age­ment excels at value destruc­tion, and that’s the con­sen­sus prospec­tive esti­ma­tion. That is, of course, unless investors esti­mate that rec­og­nized losses, which appear on finan­cial state­ments, are only a frac­tion of Citigroup’s true losses so far.

This wouldn’t be the first time that Cit­i­group under-​estimated its losses. As the Jour­nal edi­to­r­ial notes, in Octo­ber, 2007, Citi offi­cials claimed that it had only “$70 mil­lion in indi­rect expo­sure to sub­prime assets.” Now, how many orders of mag­ni­tude is that from the truth? So whether clue­less or duplic­i­tous, “why trust them?” the mar­ket seems to be saying.

In this case, it seems hard to argue with that logic.

By the way, the front page head­line of today’s paper is “Cit­i­group Ready to Shrink Itself by a Third.” We won­dered – in jest – why the sec­ond line didn’t read, “In Small Attempt to Align Assets with Equity Values.”

Like always, we may edit this post in the future, in case our early-​morning, frost­bit­ten fin­gers have erred.

Copy­right © 2009 Spero Consulting.

Foot­note:

Last Mon­day, The Wall Street Jour­nal pub­lished a small sur­vey of mostly aca­d­e­mic econ­o­mists in Experts’ Rx on How to Get Out of This Mess. (Per­haps “aca­d­e­mic econ­o­mist” is redundant.)

We couldn’t tell whether a few of the replies were poorly edited or were inher­ently trite, e.g., to para­phrase we need long-​term solu­tions, new risk mea­sures, and the abil­ity to sep­a­rate the good and bad firms. You don’t say!

Any­way, we did like Dou­glas Diamond’s response: “You have lots of car­rots and no sticks right now.”

The reporter, Justin Lahart, must have para­phrased the rest of Mr. Diamond’s reply because there were no other quo­ta­tion marks. He wrote: “One alter­na­tive would be leg­isla­tive changes that would allow reg­u­la­tors to quickly wipe out exist­ing share­hold­ers at prob­lem banks with­out invok­ing bank­ruptcy, and con­vert long-​term debt issued after the leg­is­la­tion went into effect to equity. That would effec­tively recap­i­tal­ize the bank with­out the need for gov­ern­ment money. And it would give big incen­tives to investors to buy banks’ debt, and to banks to raise cap­i­tal in order to keep their share­hold­ers from being wiped out.”

Now, we’re not­ing his remark a week after that arti­cle was pub­lished because, today, we saw on the same web site that it’s esti­mated that Citi lost another $10,000,000,000 in the fourth quar­ter of 2008. That means that it’s lost about $30,000,000,000 since Hal­loween, 2007, and that seems like a lot of money to us. We haven’t both­ered to check it, but that $30 bil­lion would be after-​tax, which means gross losses were even larger.

Of course, Citi was one of the firms that “res­cued” by the gov­ern­ment, and of that much has been writ­ten about that by many peo­ple, includ­ing at our site.

Sadly, today we also saw Mr. Bush request the “other” $350,000,000,000. (When the Feds decide to uri­nate our tax dol­lars away they do it on a scale rarely seen out­side of Nia­gara Falls.)

These recent losses and the government’s will­ing­ness to sub­si­dize make us ask: when is enough, enough?

To be clear with our read­ers, we don’t do this out of vengeance or spite or envy nor, unfor­tu­nately, even a sense of amuse­ment. In fact, we write in the spirit of the fol­low­ing excerpt from Leviti­cus 19:17 — 18, which we saw in our Mag­ni­fi­cat last week:

You shall not bear hatred for your brother in your heart. Though you may have to reprove your fel­low man, do not incur sin because of him.

Take no revenge and cher­ish no grudge against your fel­low coun­try­men. You shall love your neigh­bor as your­self. I am the LORD.

In that spirit, and con­sis­tent with Mr. Diamond’s rec­om­men­da­tion, we ask, when do we get to see the offi­cial reproof? When do these folks lose their right to con­trol assets, and when do these cor­po­ra­tions – legal enti­ties – for­feit their exis­tence and charters?

If you’re famil­iar with our writ­ings, then you know that we think they are far past that point of no return for many cor­po­ra­tions. Exactly how less trust­wor­thy must they become before the gov­ern­ment inter­venes per ours or Mr. Diamond’s recommendations?

The Curi­ous Case of Robert Rubin

The week­end edi­tion of The Wall Street Jour­nal has a front page inter­view with Robert Rubin: Rubin, Under Fire, Defends His Role at Citi.

We’ve crit­i­cized Citi’s board in the (recent) past, and we’re still par­tic­u­larly fix­ated on the fact that few direc­tors had finan­cial indus­try expe­ri­ence. That seems nei­ther wise nor even pru­dent for a finan­cial insti­tu­tion with over $3,000,000,000,000 of assets. (That’s $3 tril­lion, but we like to write it out for effect, because it seems like a lot of money.)

As the arti­cle men­tions, Mr. Rubin was “the only board mem­ber with expe­ri­ence as a trader or risk manager.”

Since 1999, Mr. Rubin has made about $119 mil­lion from Cit­i­group while hav­ing no oper­at­ing respon­si­bil­i­ties. We have absolutely no prob­lem with that, and, in fact, are look­ing for sim­i­lar “work” our­selves. (Inter­ested par­ties may use our con­tact form.)

Where we do have a prob­lem is his insis­tence that none of Citi’s prob­lems is his respon­si­bil­ity. As the inside head­line reads: “Rubin Blames Citigroup’s Woes on the Broader Finan­cial Cri­sis.” He almost seems to imply that Cit­i­group is a hap­less, unwit­ting vic­tim of some­thing big­ger than itself – some­thing it couldn’t be expected to con­sider, man­age, of fathom: “Nobody was pre­pared for this…”

In that case, exactly what type of stew­ard­ship, guid­ance, and pro­fun­di­ties did he provide? 

Sup­pose it is true that Citi and its board were fault­less. Shouldn’t they have been able to con­sider how they might be dam­aged by a gen­eral down­turn or a finan­cial cri­sis that was no fault of its (their) own. Thus, our lit­tle proof-​by-​contradiction shows the silli­ness of the argument.

More­over, we doubt that even the gullible buys the story that Citi was sim­ple a vic­tim of exoge­nous fac­tors, which were unpre­dictable and beyond its control.

There is a cri­sis of con­fi­dence, but that cri­sis erupted and sur­vives because mar­kets and investors real­ized the large finan­cial insti­tu­tions, includ­ing Citigroup, were far less com­pe­tent invest­ing and trad­ing than they pre­vi­ously believed, i.e., that in ret­ro­spect, pre­vi­ous reported prof­its were unreal and unsustainable.

Citigroup’s share price of $8.29, which is about dou­ble where it was last week­end, has lost about 85% of its value in two years. (In the first three years of the Great Depres­sion – 1929 — 1932 – the Dow Jones Indus­trial Aver­age lost the same per­cent­age with­out a back­stop by gov­ern­ment.) That is an indict­ment against Citigroup’s way of doing busi­ness far beyond the gen­eral con­dem­na­tion of the finan­cial ser­vices indus­try in gen­eral and with all of the sub­si­dies pro­vided by tax pay­ers through the var­i­ous recent gov­ern­ment guar­an­tees and bailout measures. 

Clearly, investors find fault with Citi’s strate­gic and oper­at­ing deci­sions. So, if Mr. Rubin wasn’t mak­ing oper­at­ing deci­sions, what type was he mak­ing? If they weren’t strate­gic, what remains? As other crit­ics note, Mr. Rubin is “try­ing to have it both ways.”

Of course, his pos­tur­ing is silly, as it was he, him­self, who pushed senior man­age­ment to bear more risk in 2004 — 2005. If that’s not a strate­gic, board-level, decision, what is? From our read­ing, it seems that he may now be try­ing to blame a con­sul­tant for sug­gest­ing the board instruct man­agers to take addi­tional risk.

He also blames senior man­age­ment for not exe­cut­ing the strate­gic plans prop­erly and risk man­age­ment for, well, weak risk management. 

“I wouldn’t run a finan­cial insti­tu­tion based upon someone’s view about what mar­kets would do.”

Of course, as the arti­cle explains that is exactly what he did in 2004 — 2005. (We wouldn’t doubt that he did it at other times, too, but don’t have the time or energy to search for quotes or sto­ries.) Well, he didn’t do it based upon some­one else’s view; instead, Citi’s strat­egy seemed to be based upon his own views. (We could well imag­ine board­room dis­cus­sions where inex­pe­ri­enced direc­tors imme­di­ately defer to the for­mer Trea­sury Sec­re­tary and Gold­man Sachs Co-​Chair.

Now, Mr. Rubin should know that devel­op­ing and acknowl­edg­ing such a world-​view is exactly how finan­cial insti­tu­tions are run, whether that view is explic­itly stated or not. (If it is not explicit, then not pro­vid­ing such a view and or con­sid­er­ing its impli­ca­tions seems neg­li­gent at worst and imma­ture at best, ergo, our title.) What else could strate­gic and oper­at­ing plans be based upon? How else could risks be mea­sured, uncer­tain­ties be con­sid­ered, and con­tin­gen­cies be planned? Or are those con­sid­er­a­tions too much like work? If so, it is not dif­fi­cult to see why Citi is where it is at this Novem­ber, and that is com­pletely con­sis­tent with both a spe­cific and the more gen­eral cri­sis in confidence.

As we see it, Mr. Rubin is seventy-​years-​old. He should grow-​up and accept the respon­si­bil­i­ties that come with his posi­tion and rewards, and stop behav­ing like a petu­lant teenager.

Bill’s and Bill’s, Bill’s and Bill’s
It’s bailout time, for the Citi
Plead-​a-​ling, hear them sing
To-day, it is our bail-​out day!

Citi side­ways, Wall Street side­ways
Dressed in bank hol-​i-​day style
In the air there’s a feel­ing of Christ­mas
Bankers laugh­ing, taxes pass­ing
Wast­ing pile after pile
And on every street cor­ner you’ll hear…

Trill’s and Trill’s, Trill’s and Trill’s
It’s Christ­mas time for the Citi
Plead-​a-​ling, hear them all sing
“We want our own bail-​out day!”

*With all due respect and apolo­gies to Ray Evans and Jay Liv­ingston and their clas­sic, Sil­ver Bells, and for the truly clue­less, note that we’re abbre­vi­at­ing bil­lions and tril­lions to fit the tune.

Update: Well this post is already obso­lete, but we stand by our crit­i­cism. We tax pay­ers should not sub­si­dize Cit­i­group shareholders.

Tonight (Novem­ber 23), The Wall Street Jour­nal reports in Bailout Talks Accel­er­ate for Ail­ing Cit­i­group that the gov­ern­ment is nego­ti­at­ing to be the resid­ual claimant of a sep­a­rate entity that would house Citigroup’s worst assets and deriv­a­tive bets.

Cit­i­group could lose up to $50,000,000,000, and then the gov­ern­ment would absorb the losses. It is kind of like buy­ing flood or hur­ri­cane insur­ance after the flood or hur­ri­cane. (Seems kind of silly and like a mas­sive sub­si­diza­tion of a lot of bad decisions.)

If that’s the case, wouldn’t that guar­an­tee make tax pay­ers the resid­ual claimants of the entire entity?

Let’s rephrase our ques­tion in another way: in nego­ti­a­tions between (1) inter­ested and profit-​motivated Cit­i­group bankers and (2) less inter­ested gov­ern­ment appointees and fed­eral civil ser­vants with no claims on the assets, does the reader believe the expected losses – or, pos­si­bly the privately-​known, undocumented, extant losses– will be greater or less than $50,000,000,000?

So, shouldn’t the tax pay­ers own the entire entity?

Unfor­tu­nately, it’s not clear whether the gov­ern­ment will get any equity share of the “good” bank.

Now the reader might argue that it would be dif­fi­cult to lose $50,000,000,000 on $2,000,000,000,000 (that’s tril­lion) of assets; so, there’s really not much sub­si­dizin’ goin’ on.

First, if that were the case, then there really wouldn’t be any need for a sub­sidy would there?

Sec­ond, it turns out that the $2,000,000,000,000 is a bit on the low side. Cit­i­group has more than $3,000,000,000,000 of assets when its off-​balance sheet assets are included.

By the way, that increase of a $1,000,000,000,000? The arti­cle men­tions that $667,000,000 of it are in mortgage-​related secu­ri­ties. (They’re prob­a­bly of the high­est cal­iber because, you know, every­one tries to hide their most valu­able assets in off-​balance sheet accounts.)

We love the sen­tence: “Cit­i­group has tried repeat­edly to rid itself of its expo­sure to those assets.” Do ya think?

We start­ing a new con­ven­tion of writ­ing all the trail­ing zeroes. We think it com­mu­ni­cates the size of the stakes more clearly. Things like three-​digit “bil­lions” and one-​digit “tril­lions” are so abstract, but nine or twelve zeroes mean some­thing. We do wish that the bureau­crats within the gov­ern­ment and with firms would start­ing fol­low­ing suit.

As we wrote on Fri­day, if US tax pay­ers are sup­posed to cover the down­side, they should get the upside, too. This isn’t like deposit insur­ance, where there was a prior con­tract and exchange of pre­mi­ums for pro­tec­tion. This is the sub­si­diza­tion of mistakes.

Guar­an­tee­ing the bad bank is bad indus­trial pol­icy, and it would accel­er­ate mas­sive merg­ers (in attempts to become too big too fail) and exac­er­bate moral haz­ard as there would be no down­side to failure.

We say: Nation­al­ize Citi. Wipe out the own­er­ship inter­est of all exist­ing share­hold­ers, except non-​executive employ­ees with restricted stock, and let them retain the same own­er­ship inter­est in a new entity when it is privatized.

Do it as a les­son to other banks to find cre­ative ways to improve the cred­it­wor­thi­ness of their indi­vid­ual insti­tu­tions. That’s prefer­able to pledg­ing much of our nation’s cur­rent and future wealth to a small sub­set of its cit­i­zens, who hap­pened to own bank stocks in 2008.

With­out try­ing to be melo­dra­matic, we ask: who’s chil­dren and grand­chil­dren should pay for and sub­si­dize Citi’s errors?

Note: We’ll likely expand and edit this post in the morn­ing, but wanted to cir­cu­late the idea before bedtime.

We’re rather dili­gent – but not obsessed– about keep­ing up with finan­cial new.¹ We’ve heard many finan­cial firms announce lay-​offs and have read how at a few, like Gold­man, senior man­agers have decided to forgo bonuses.

As we recall, most banks have announced with­drawals from sub­prime mort­gage orig­i­na­tion and loans, which seems like a wise move, but given the mag­ni­tude of their errors and mis­takes, we’re very sur­prised that we haven’t read more about banks tak­ing dra­matic and dras­tic actions to limit risks and exposures.

We don’t mean hoard­ing cash and the knee-​jerk reac­tions not to lend. We’re think­ing more about their invest­ing, trad­ing, and struc­tur­ing operations.

Maybe the banks are elim­i­nat­ing desks and floors, but they just aren’t talk­ing about it, or maybe they have men­tioned it, but we’ve missed it.

We’d cer­tainly encour­age finan­cial firms to change their ways. In fact, while we’re close to Lib­er­tar­ian on many eco­nomic issues, we wrote on Octo­ber 11, to Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions as a way to mit­i­gate moral haz­ard and pro­tect tax-​payer interests. (Once they’re insured, it is no longer a free mar­ket, and there should be quid pro quo, not just subsidization.)

On Sep­tem­ber 24, in our post Could a “Bailout” Pro­long the Finan­cial Cri­sis?, we wrote:

So, if the government’s pur­chase of these thin­gies is approved, we would expect to see a con­tin­u­a­tion of the pan­icky behav­ior until the secu­ri­ties are actu­ally trans­ferred to the gov­ern­ment because it is unlikely that any­one will know who has the worse ones so (means that) all remain sus­pect. (Also note that the most pan­icky firms might be ones who are pro­ject­ing their port­fo­lios onto oth­ers, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity mar­ket per­for­mance, par­tic­u­larly among finan­cial firms, sup­ports our Sep­tem­ber 24^th pre­dic­tion above, i.e., the con­tin­u­a­tion of pan­icky behav­ior until actual trans­fers occur. We dis­cussed related issues on Octo­ber 7, in Even A Per­fect Bailout Will Fail.

Or maybe they’re just tak­ing a wait-​and-​see approach. That’s what we pre­dicted in early Octo­ber when we described the very high prob­a­bil­ity of fail­ure of TARP.

Today’s Wall Street Jour­nal reports that Citi Weighs Its Options, Includ­ing Firm’s Sale, and we won­der if it will sur­vive the weekend.

As we argued in Big­ger Is Not Nec­es­sar­ily Bet­ter way back in Sep­tem­ber, we see no rea­son to encour­age mega-​mergers and we based that argu­ment on both moral haz­ard and sys­tem­ati­za­tion of idio­syn­cratic risk considerations.

So, as we argued in around Octo­ber 10, we believe that It’s Time! to nation­al­ize the worst offend­ers leav­ing no share­hold­ers, except non-​executive employ­ees, with any own­er­ship inter­ests. We reit­er­ated much of the same argu­ment in a very long post from Wednes­day: OMG, Mr. Paul­son Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we tax­pay­ers will be on the hook for Citi, any­ways, so why not elim­i­nate the mid­dle­man and pro­vide any upside ben­e­fit to the true resid­ual claimants?

In two recent posts, The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit, we’ve crit­i­cized the com­po­si­tion of Citigroup’s board because of their gen­eral lack of finan­cial indus­try expe­ri­ence. (We’re sorry, but that seems uncon­scionable to us.)

We won’t repeat all of our argu­ments for nation­al­iza­tion, but the expro­pri­a­tion of Cit­i­group would cer­tainly moti­vate other banks to act quickly and largely to mit­i­gate risks and sta­bi­lize cash flows. (It would likely stop insur­ance com­pa­nies and oth­ers from buy­ing small banks or S&Ls in their beg­garly attempts to become bank hold­ing companies.)

By the way, for new read­ers, we’re not just for the nation­al­iza­tion of a few banks, we actu­ally have a pri­vate solu­tion for the mort­gage cri­sis that involves pro­vid­ing the right tax incen­tives – like invest­ment tax cred­its – to indi­vid­u­als, firms, and fund man­agers. (Read about it here: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

That solu­tion to the mort­gage cri­sis stills leaves the larger liq­uid­ity or con­fi­dence cri­sis for banks. That has arisen because the mort­gage cri­sis has informed us (and oth­ers) that despite their pseudo-​sophistication and the veneer of objec­tiv­ity and sci­ence (almost), there is a very good chance that they don’t under­stand their envi­ron­ment or have reli­able ways to value many of their prod­ucts – despite their mas­sive invest­ments and activ­i­ties for those pur­poses. In terms of an adverse selec­tion prob­lem, they’ve reveal them­selves to be low types. (See last week’s Global Warm­ing and the Mort­gage Cri­sis for a dis­cus­sion on that topic.)

So, as a nation, we should want (and attempt to moti­vate) the banks to act quickly and deci­sively (and with their pri­vate infor­ma­tion) to get their accounts in order.

The ben­e­fits of TARP don’t seem to have pro­vided the cor­rect moti­va­tion to the bank­ing firms to act to main­tain their own liq­uid­ity and cap­i­tal posi­tions. We’d argue that this is an incen­tive prob­lem and that if the ben­e­fit of the TARP “car­rots” have been insuf­fi­cient moti­vate socially-​optimal behavior. So, per­haps a “stick,” like the threat of expro­pri­a­tion, induce clean-​up. More­over, it is seems that Citi will be ours any­way, so, why not give it a try on tax­pay­ers’ terms rather than tax­pay­ers’ backs?

We very much enjoyed the arti­cle, As Firms Floun­der, Direc­tors Quit, in today’s (Novem­ber 21) Wall Street Jour­nal.

The title com­pletely sum­ma­rizes the con­tent: as many firms have faced finan­cial dif­fi­cul­ties, out­side direc­tors have quit because they’re “too busy” to direct the firm that they agreed to help direct before it was in such dire trouble.

A week ago Thurs­day, we wrote The Fail­ure of Boards to Direct in response to a dif­fer­ent WSJ arti­cle about Cit­i­group. We con­sider the key line of the arti­cle to be an off-​hand ref­er­ence to the fact Richard Par­sons was “one of the few Cit­i­group direc­tors with expe­ri­ence in financial services.”

One of the few! $2 tril­lion – that’s $2,000,000,000,000 – of assets and a mar­ket value of $25 bil­lion. Despite the ben­e­fi­cial gov­ern­ment sub­si­dies and guar­an­tees of many lia­bil­i­ties, that mar­ket value is barely over one per­cent of the assets at work.

So we ask: do you think that there is a rela­tion­ship between a(n at least par­tially) unqual­i­fied board of direc­tors and the prob­a­bil­ity of fac­ing finan­cial dif­fi­culty – if not out­right ruin – par­tic­u­larly dur­ing a global crisis?

If not, why not?

We do note, how­ever, if this cur­rent dis­com­fort demo­ti­vates dilet­tantes from serv­ing on other boards in the future, then maybe some good will come out of the crisis.