brollyI’ve been reading some of the reactions to the announced plan to backstop certain obligations of Citigroup, Inc. (Citi)  Many people seem to be, potentially rightly, outraged that their tax dollars are being put to work to prop-up U.S. financial institutions without taking a pound of flesh — i.e., firing senior management, putting compensation caps in place, etc.   Further, people are running through the streets screaming “where’s the plan, where’s the plan”, a reference to the log jammed proposed bailout of the U.S. automotive industry.  While I do not begrudge people for their level of disdain as it relates to what is going on, I do think that some of the commentary shows a lack of foresight and a misunderstanding as it relates to the nature of our underlying economic systems and importance that money centered banks play relative to industry.  That said while salvaging our banking system is a fundamental choice that must be made, that is not to say it is a better one.

First, I think it is worth laying out my view that absent rampant speculation and the rapid media syndication of fear, Citi would not have needed any government support, even though it might be in the best interest of equity holders.  One could argue that Citi’s balance sheet is stronger now than at this same time last year.  In fact, if not for shortsellers and fear mongers, we might not have seen Bear Sterns and others go under (likely Lehman, but not Washington Mutual, Wachovia and the like).  Generally speaking, financial contracts if fulfilled or unwound in an orderly fashion allows for reasonable matching between assets and liabilities and inflows and outflows.  Where financial institutions experience a deluge in counterparties seeking contract enforcement in an accelerated fashion, the system can become materially imbalanced and confidence can dissipate.  Many of the surges we have recently experienced have been the result of speculation, as opposed to material fact with confirmation, that emanated from those who stood to profit from such turmoil.   This is a referendum, in my opinion, on the evolution of our greed is good immediate gratification culture that reacts based on half truths and ask questions later.  Greed at the expense of what is in the best interest of our financial system makes me a little ill. Exhale.

So why bailout Citi without hesitation while holding the automotive companies feet to the flame?  In short, because the first is essential to the stability of our financial system and therefore our economy and the second is not.  While this is a painful realization for many who were raised in another era, it is in fact true.  Until recently, Citi was the largest U.S. financial institution (today it is 4th by market capitalization (excluding Canadian deposit institutions listed on the NYSE); 5th by deposits), the symbol of the new financial order that married banking with brokerage and insurance.  The deal was so significant that the U.S. government set aside the Glass-Steagall Act to get it done.  As a result, Citi was allowed to grow into a behemoth, commanding over $2 trillion in assets and employing 300,000 people in 100 countries.  What I find somewhat ironic is that the Democratic party inherits a mess made by the last Democratic president.

If Citi were to be allowed to fail, or forced to, it would undermine a, if not thee, central pillar of the U.S. financial system,  not run by the government, even if it is one that is fatally flawed (net, net the deal that built Citi should have never been allowed to happen).  A Citi collapse would lead to a run on countless U.S. banks and foreign financial institutions, the result of which would meaningfully undermine credit based commerce, globally.  Further, Citi, as one of the largest issuers of credit cards, could be forced to bring down a healthy percentage of the U.S. consumer population with it.  That is not good for business.  If savers do not believe financial intermediaries are sound, they won’t save.  This is why the government regulates these bodies and provides depositors insurance.  A run on Citi would recreate the 1930s all over again.  Given the fragility of the U.S. economy, spooking savers and consumers would not be in our best interest.

So why not see off company senior management and the board as part of the stabilization of Citi?  I’ll take the second question first (I’ve always wanted to say that).  There should have been government mandated changes to the Citi board.  The person who put Citi squarely in this mess was Charles Prince.  Passed over by Sanford Weil during these years was Jamie Diamond, now head of J.P. Morgan Chase.  You don’t see him with his hand out.  Further, the board, namely at the behest of Robert Rubin, pushed the bank to expand into more risky trading activities as a means to fuel growth.  It was these very trading activities which ultimately created Citi’s toxic balance sheet.  Finally, board also failed to push current Citi CEO Vikram Pandit to enact significant cost cutting measures on an accelerated timeframe.  The board is large, unwieldy and needs to be held accountable.  They lack a connection to reality.

As for management, broad sweeping changes and a removal of financial incentives would result in significant chaos at the bank.  At this point in time, that would be a counterproductive measure.  Capping bonuses and the like would only deincentivize managers from pursuing what is in the best interest of shareholders.  If such incentives are removed, and management departs as a result, the company’s ability to attract high caliber talent to replace departing employees will be serverly hampered.  Afterall, why would you want to inherit this mess? Rhetorical question.

In contrast to Citi, the U.S. automotive industry has been trying to get its seat at the bailout buffet, but has been, shall we say, re-buffed.  Congress wants Detroit to hatch a plan for utilization of the funds that shows it would make them economically viable.  The problem is that no amount of money is likely to make that a reality.  U.S. auto companies are woefully behind their foreign peers in manufacturing efficiency, engineering acumen and, most importantly, an understanding of consumer demand.   No amount of money will be sufficient to change the mind of U.S. consumers who have long abandoned our auto industry.  A friend of mine came up with the great idea that consumers should be offered significant tax credits to buy U.S. autos.  We seemed to agree on $5,000, when challenged he made no movement to get his keys.  When I raised the ante to $10,000 he did not twitch.  Maybe I should have simply offered to give him the car.

Yes, a failure of the big three will cost jobs and bring about regional and national economic malaise and generally be bad for organized labor and national morale, but a failure to bailout the automotive industry will not result in global thermo nuclear financial meltdown.  In fact, I could make a strong argument that the auto industry should be saved and Citi should be allowed to fail (uber economist Robert Reich seems to agree), but the risk of this flip-flop, assuming one not the other, is just too great.  Bankruptcy is a viable option for Detroit, but not the banking community.  Ultimately, I think this is where they will end up. 

The above is not to gloss over the serious flaws in our economy, our economic system and our core financial institutions.  There are and they will need to be addressed.  Peter Schiff is grinning a mile wide while Ben Stein is frowning (see herefor context). U.S. industry is is going to need to find ways to create sustainable economic advantage.  In the mean time, we should expect to move sideways or slowly trend down.  I’m sorry to inform folks that the Internet economy ushered in by Greenspan was in fact one big asset bubble, in case you missed the memo.  We will need to rebuild our fundamental cash flow base.  Namely our manufacturing base need to be rebuilt and our service sector demphasized. Asset values will need to be reset and consumer credit reigned in.  As I have stated elsewhere we need to take our medicine and the pain with which it is associated.

/bryan 

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