The travails of Citigroup point to a challenge that goes beyond the survival of one of the world's largest banks: Government actions have so far failed to contain the problems shaking the financial industry.
Barely three weeks ago, Citi was one of a handful of banks to receive big infusions of capital from the US Treasury – a move designed to bolster market confidence.
But since then, the bank has lost about 70 percent of its stock market value and, by Sunday night, it became the recipient of a large new federal bailout. It isn't Citi alone that's faltering. The stock value of America's financial sector as a whole fell by nearly 40 percent in that same period since Oct. 28.
If a $250 billion program of recapitalization wasn't enough to prop up America's credit industry, what will?
Various approaches are possible, but any strategy may need to grapple with two problem areas central to Citi's troubles:
•Complex and risky investments have created much of the uncertainty about the health of financial firms. The Treasury recently backed off from a plan to buy these troubled assets, but Sunday’s rescue of Citigroup centers around the notion that some way of transferring this risk can speed a banking recovery. In particular, a decisive approach may be required on a web of contracts that insure against borrower defaults – promises known as credit default swaps.
•Economic conditions are adding new uncertainty for banks. The more consumers retrench and the more people lose jobs, the more loans become delinquent. This risk might be mitigated by new economic stimulus measures – now at the forefront of President-elect Obama’s agenda.
"The economy is deteriorating tremendously fast," says Raghuram Rajan, a finance expert at the University of Chicago. "The concern is how much more [risk] is there. This stuff seems unbounded. That's what the investor is really worried about at this point."
In announcing the new rescue package for Citi, arranged jointly by the Treasury and the Federal Reserve, the Fed’s board of governors said they were balancing several concerns: helping the flow of credit resume for households and businesses, being prudent about the use of taxpayer dollars, and limiting the involvement of government in the private sector. Ultimately, the Fed said it hopes its efforts will “bolster the efforts of financial institutions to attract private capital.”
Those goals aren’t easy to balance.
In the bailout, the Treasury and the Federal Deposit Insurance Corp. (FDIC) will provide protection against large possible losses on a pool of $306 billion of loans and securities backed largely by real estate, which will remain on Citigroup's balance sheet. In return, Citi will issue preferred shares to the Treasury and FDIC.
In addition, the Fed agreed to backstop residual risk in the asset pool through a nonrecourse loan. And the Treasury will invest $20 billion in Citigroup from its Troubled Asset Relief Program – the $700 billion financial stabilization fund created by Congress in October.
Citi agreed to pay an 8 percent dividend to the Treasury on the preferred shares, to increase restrictions on executive pay, and to implement the FDIC's mortgage-modification program to minimize the number of home foreclosures.
As the Citi bailout implies, navigating through the credit quagmire is proving to be very tricky for policymakers, because of the size and complexity of the institutions involved.
Citigroup in particular is among those considered "too big to fail." A core task for the Treasury and bank regulators is to try to keep the channels of credit functioning as smoothly as possible – a goal that argues for rescuing troubled institutions.
But that means putting taxpayer money on the line. Often a bank rescue involves wiping out shareholders, so that taxpayers are not asked to bail out investors. In the Citi rescue, the new preferred shares owned by government in effect dilute the stake held by common shareholders. But eventually, the government wants the industry to function normally again with private-sector investors being confident enough to provide the capital. Thus the government doesn’t want a total nationalization of a troubled bank, if that can be avoided.
Private capital sources for banks, however, have all but dried up. Investors are unsure about both the state of bank balance sheets and about the prospect that, for now, the government will be taking bigger and bigger equity stakes in banks.
The plunge of Citi's share price last week reflected these concerns.
"What you're seeing is the markets telling you that equity holders are dead," says Christopher Whalen of Institutional Risk Analytics, which tracks the banking industry.
Although Citi's problems are worse than those of many banks, it is hardly alone in its exposure to risk. Mr. Whalen predicts that the government will be almost "the only provider of capital to bank holding companies for the next year."
In the case of insurance giant AIG, the government has injected money to rescue the company, and in the process has become the largest equity holder. Taxpayers thus stand to gain if the company recovers.
But for now, losses in AIG's credit default swap (CDS) portfolio are devouring federal resources. The size of the rescue effort recently doubled to about $150 billion, and it's not clear how high the tab will ultimately go.
Citigroup also has large CDS exposure, bank analysts say. Also, the souring economy last week raised new doubts about the value of securities tied to commercial real estate mortgages – another area where Citi has a significant stake.
Both for big institutions and for the industry in general, financial experts see a range of possible new steps to augment the Treasury's capital-infusion program.
One idea is to buy up troubled assets that weigh on bank balance sheets. This idea, an initial goal of the Treasury in the rescue package approved by Congress last month, should be revived in some form, says Mr. Rajan in Chicago.
"The cost may be higher than we've budgeted for so far. But it may be time to bite the bullet and do it," he says.
Often, financial crises have a high cost – 15 to 20 percent of a year's gross domestic product in an affected country, he notes. But the quicker bad assets can be purged, the quicker the system can function again.
He also recommends forcing banks to temporarily stop paying shareholder dividends, a move that would conserve capital and make other government rescue moves more politically palatable, since shareholders will be shouldering a burden.
Another big idea is to resolve the CDS issue. Credit default swaps total trillions in value, and in many cases the contracts were purchased not as genuine insurance (by the holder of a bond) but as a speculative investment that will pay off if the bond defaults.
Whalen calls for a mandatory unwinding of these contracts, in which purchasers who were genuinely hedging a risk would be covered, while speculators would lose much of their potential gains from the investment.
Without some action along that line, CDS obligations could become a black hole for the banking system, he and others warn.
"These things are like land mines," says Michael Greenberger, a former regulator of derivative contracts at the Commodity Futures Trading Commission. "Every indication is that they are at the heart of the financial crisis."
He says a first step is to take an inventory of CDS contracts, since poor regulation makes this market opaque.
He also says it may be necessary to push speculators to take a hit on the value of their contracts. This might be in their interest, he says, since the companies offering the contracts might not survive if they must pay the full amount.
Finally, economists say that a large economic stimulus package, if it helps slow the pace of the current economic downturn, would reduce the rising losses that banks face on everything from real estate to credit cards and business loans.
This story was updated at 9:30 a.m. Nov. 24, 2008.