“Sharing” Citigroup’s losses above $29bn, as agreed in the US bailout plan for the group finalised Sunday night, doesn’t sound too promising for US taxpayers. What’s worse is that the amount may not be enough.
For a start, the $27bn being injected in the form of preferred shares will do little to stem further losses, which come out of common equity (discussed at length, here and here). To send further chills down taxpayers’ spines, see this calculation from Rolfe Winkler at Option ARMageddon:
That’s frightening for a couple of reasons. Firstly, as Winkler notes, it means the bank has $56 of assets for every $1 of common equity. — or a leverage ratio (assets/equity) of 56. With leverage of 56, if the value of those assets were to fall 2 per cent (not so unlikely in the current writedown-prone environment), then common stockholders are wiped out. This tallies roughly with FBR’s argument last week for the need of $1,000bn in tangible common equity to absorb losses stemming from what is essentially an over-leveraged financial system.
Secondly, the calculation doesn’t include Citi’s off-balance sheet assets — which amount to something like a whopping $385bn according to FBR. Winkler uses a mortgage comparison to explain the problem of over-leveraging in relation to assets and equity:
Just like you save for a down payment and borrow money to buy a house, a bank will take deposits, sell debt and raise equity capital to make loans. But if the value of its loans fall, then it has to write down them down by that amount. To keep the equation in balance, if it writes down assets, it must simultaneously write-down equity by the same amount… As it does with our imaginary home-borrower, the leverage ratio tells us how much cushion the bank has to lose money on the asset side of the balance sheet before equity goes negative. The higher the leverage ratio, the less cushion.
This is why we’ve seen share prices, specifically Citi’s, plunging — with so many banks (and people) leveraged to the hilt, it takes only a small change in the value of assets to lead to a massive decline in equity. It’s also why the US government has so far focused on snapping up assets. Winkler explains:
All of these government bailouts, er, ‘guarantees’ are simply a transfer of risk from the balance sheets of various financial companies to governments’. To prevent ‘A’ from falling too far, and thereby wiping out the ‘E’ of the financial companies, the government absorbs the assets itself, immunizing the financial companies from loss.
Of course, another way to do it would be to inject some common equity to absorb the losses. This would arguably help set a floor for assets (specifically mortage-related assets) and start restoring confidence, rather than artificially prop up share prices and balance sheets.
Interestingly, Felix Salmon also picks up on the mortage theme in relation to share prices falling to zero:
… the whole leverage aspect I think is not well understood by the public. They know that if they buy a house with little or no money down, that means they have very little equity in the house and that equity can be quite easily wiped out, even if the house is still worth something. But they don’t look at stocks the same way: they don’t think of shares in Citigroup as equity in a house with a 90% mortgage…
If enough stocks go to zero during this stock-market downturn, that might change. Especially if and when companies start emerging from bankruptcy in listed form, the public might start to realise that companies don’t necessarily die along with their stocks, it’s just that their owners change.
Related links:
Tangled tangibles - FT Alphaville
Wanted: $10,000,000,000,000 to bailout the financial system - FT Alphaville
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