04/03/2009 09:36 am ET Updated May 25, 2011

Nationalizing Citi

On Monday, March 23rd, Treasury Secretary Tim Geithner revealed his plan to deal with toxic bank assets: a Public-Private Investment Program. While Geithner's strategy was well received by the stock market, leading economists - notably Paul Krugman - remained dubious. They fear Geithner is avoiding the inevitable - "nationalization" of large banks - and the longer the delay, the bigger the problem. What would it mean to nationalize a bank as large as Citigroup?

Almost every week the Federal Deposit Insurance Corporation takes over a failing bank. Typically these are relatively small institutions, with a few million dollars in assets, and the FDIC arranges for them to be acquired by a neighboring bank. But Citi has roughly $2 trillion in assets. It's one of the world's largest financial institutions, offering diverse services including investments and insurance. (Citigroup is the holding company; Citibank is the bank component, and Citi is the term commonly used to refer to them.)

Currently, there are roughly $12 trillion in US bank assets. More than half are held by four gigantic US bank holding companies: JPMorgan Chase, Citi, Bank of America, and Wells Fargo. (These four plus HSBC - the Hongkong and Shanghai Banking Corporation, headquartered in London - account for 95 percent of trading in the complex derivatives that many believe precipitated the bank crisis.) Citi, Bank of America, and Wells Fargo are said to be teetering on the edge of insolvency.

Citi is the weakest. A March 2nd TIME analysis by Stephen Gandel indicated Citi had an equity-to-asset ratio of 3.8 percent, significantly below the 5 percent the market expects as the minimum requirements for viability. (At its current price of approximately $2 per share, Citi is worth roughly $14 billion, far less than the $50 billion the US government has invested in it.)

A November 23rd New York Times article, traced the recent history of Citi as it broadened its scope of business and began to engage in a wide variety of financial activities. With this expansion came problems of control and oversight. Earning pressure caused Citi bond traders to increase participation in risky markets, particularly collateralized debt obligations, which repackaged sub-prime mortgages for resale to investors. The expansion of this niche business was fueled by its profitability - fees were unusually high and, therefore, traders made million in bonuses - and the lack of oversight.

Two years ago, Citi was the world's largest financial company. The collapse of the housing bubble caused its stock to plummet from $26 to $2 per share. Nonetheless, many observers feel that the full extent of Citi's exposure from bad assets has yet to be accurately expressed. NEW YORK TIMES financial writer Joe Nocera notes there are two categories of toxic assets. The first is "mortgage-backed securities have been marked down to levels that have started to approach reality... under mark-to-market rules." Experts estimate that Citi has marked down its mortgage-backed securities to one-third of their original value.

The second category of toxic assets is non-securitized loans. Citi has more than $660 billion in large loans: buyout, commercial, credit card, and small business loans. Because of lax regulations, these loans do not have to be marked to market. In many cases, Citi hasn't acknowledged these loans are in deep trouble. A recent noted at the end of 2008, Citi "had potential current losses of $140.3 billion, exceeding its $108 billion in reserves, and future losses of $161.2 billion." Geithner's Public-Private Investment Program will focus on this toxic loan portfolio.

As one of the world's largest financial concerns - with 250,000 personnel in 12,000 offices in 107 countries - many believe Citi is "too big to fail." Federal officials point to the abrupt dissolution of Lehman Brothers, and the catastrophic immediate consequences of the failure to wind it down slowly, as evidence that insolvent humongous bank holding companies have to be handled very carefully. Since November, the Federal Government has invested $50 billion in Citi.

Besides size, there are two practical reasons why the Federal government has yet to nationalize Citi. It's an international institution, and its largest stockholders include Saudi Prince Prince Walid bin Talal, the governments of Kuwait and Singapore, and Pacific Rim investment groups. Foreign investors hold much of Citi's $486 billion debt. The bank's main deposit base is overseas. Therefore, the nationalization of Citi would have worldwide consequences.

Nonetheless, the main problem appears to be pragmatic. TIME financial writer Justin Fox noted "FDIC chairwoman Sheila Bair and Fed Chairman Ben Bernanke have both said they don't have the authority to wind down global financial conglomerates like Citi." In his most recent appearance before Congress, Treasury Secretary Geithner asked for this authority: "we must create a resolution regime that provides authority to avoid the disorderly liquidation of any [bank holding company] whose disorderly liquidation would have serious adverse effects on the financial system or the U.S. economy." Citi can't be nationalized until new laws are passed.

Once new regulations take effect, it's likely the Geithner-Bernanke-Bair team will nationalize Citi and Bank of America. (In Bernanke's words they'll be "wound down in a safe way.") America's humongous bank holding companies will be broken up; the new entities that hold toxic assets will file for bankruptcy.