And You Thought the Vapours Were a One-Hit Wonder

Yes, we're turning Japanese. Naked Capitalism's Yves Smith writes:

There is a remarkable failure to acknowledge a key element of the task before us, that is, that the financial system HAS to shrink. Its current size is based on an unsustainable level of debt, a big chunk of which will go bust or be renegotiated. Yet rather than trying to figure out what a new, slimmed down version of banking ought to look like, to ascertain which pieces should be preserved and which jettisoned, the authorities are instead reacting in a completely ad hoc fashion, rushing to put out the latest fire. And in the process, they keep trying to validate overly inflated asset values (a measure straight out of the failed Japan playbook) rather than try to ascertain what their real value might be so as to determine how much recapitalization might ultimately be needed (if you doubt me, Exhibit One is the pending Citi bailout, in which lousy assets will be guaranteed at phony values).

Everything they do shows that our current set of policymakers are still in deep denial about the massive de-leveraging occurring in our economy. There were far better solutions to the Citi problem than propping up toxic assets that could easily turn out to be worth pennies on the dollar. John Hempton writes:

I suggested that Sheila Bair might seize Citigroup precisely because it is the sort of irrational, arrogant and dumb thing she does....

It is open to Sheila Bair (and her fellow regulators) to seize Citigroup (deeming it unsound) and to leave at the holding company – and worth near zero – all the equity, preferred shares and holding company debt obligations. Indeed this is precisely what she did at Washington Mutual. What she did once she might do again.

This will in fact result in a full successful resolution of the Citigroup problem at no cost to the government from Citigroup. There is a darn strong case for doing it....

There are 17.5 billion in short term parent company debt and 117.5 billion in parent company debt with more than a year’s maturity. There are a further 27.4 billion in perpetual preferred securities and 28.5 billion in subordinated debentures.

If Sheila Bair confiscates Citigroup and leaves all those liabilities at the holding company then it is economically the equivalent of a 184 billion dollar equity injection into the remaining group. A cancelled liability of course is the equivalent of new (non cash) capital.

The new Citigroup should be adequately capitalised – albeit government owned. The FDIC could IPO the new Citigroup once this market mess had died down (and remit most the proceeds to former bond holders). A shrinking Citigroup with an additional 184 billion in capital shouldn’t cost the government anything.

But that didn't happen. Why? These were grown up investors who knowingly took on risk, they are not innocent children. Why are our policymakers leaving holders of Citi securities (both debt and equity) unscathed while the taxpayer is now on the line? What happened to capitalism?