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And now we return you to coverage of the financial crisis

November 21st, 2008

The failure of Citigroup, which looks increasingly likely to happen in the near future, would mark the end of the beginning of the financial crisis. Until now, the prevailing view has been that the crisis and recession will pass in a year or so, after which things will go back, more or less, to the way they were, with a few less financial institutions, and a bit more regulation. A Citigroup failure would put paid to that idea.

Citi is not only too big to fail, it’s too big to rescue with any of the half-measures that have been tried so far. Only outright nationalization is feasible, and that will probably require joint action by a number of governments; Citigroup’s global operations are too big for the US to handle alone. After that, the kinds of tinkering discussed at the G20 last week will be irrelevant. It’s now unsurprising to read (on CNBC!) predictions that all US financial institutions will be nationalized within a year. That’s probably an overstatement: as long as the economy doesn’t really crash, there are plenty of small banks and credit unions that will survive, but few of the big names will be among them.

Not only major institutions but whole national economies are up for grabs now. The national bankruptcy of Iceland seems likely to followed by something similar for Switzerland. As Citi itself points out, UBS and Credit Suisse are bigger, relative to the Swiss economy, than Kaupthing was for Iceland. Felix Salmon (also predicting doom for Citi, has been all over this).

Given a failure and rescue, Switzerland would probably have to follow Iceland in a rush application to join the EU (which might have its hands full rescuing some of its own members). It’s a safe bet that the end of secret bank accounts, “wealth management” through tax minimisation and the like would be part of the price. The UK isn’t quite as vulnerable, but seems likely to be forced into the eurozone before long (for a contrary view, see Martin Wolf) And this will be accompanied by a big structural shift away from the dominance of these economies by the financial sector.

If even part of this plays out as it seems likely to, the financial system that emerges from the crisis will be radically different from the one that went in: massively smaller, with far fewer institutions and products, and tightly regulated where it isn’t under outright public ownership.

But before we can even get to that point, we’ll have to survive a global recession which is already the worst in decades, even though it’s still in the opening phase where unsold inventories pile up on wharves. Obama’s inauguration is going to look a lot like that of FDR in 1933.

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  1. BilB
    November 22nd, 2008 at 05:35 | #1

    I wonder where Sol Trujilo parks his annual cash stash in this environment. The government will be pleased with his 13 million salary as its tax share of that will be one of the bigger dividends it gets from Telstra these days.

  2. bill broome
    November 22nd, 2008 at 06:16 | #2

    Is there any event, or combination of events, that would cause mandarins of academia to say: “I have changed my mind, capitalism doesn’t work well enough- let’s try socialism.”

    Or is that a career wrecker?

  3. Ernestine Gross
    November 22nd, 2008 at 07:34 | #3

    Regarding Felix Salmon’s data:

    Relating the numbers in the balance sheet of banks to the numbers of national aggregates, such as GDP, of the countries in which the banks are domiciled is perhaps meaningful if the legislation (and the implied obligation toward tax payers)in the countries is about the same.

    Perhaps I am mistaken in the belief that one of the distinguishing features of the Swiss banking system (legislation) is that it guarantees secrecy. This is not the same as an explicit or implied deposit guarantee. If I am not mistaken, then the implication of a (hypothetical) Swiss bank failure is very different from the actual bank failure in Iceland, even though the ratios calculated by Salmon suggest otherwise.I am suggesting that the economic capacity, as measured by GDP, of Switzerland to underwrite the deposits is not as relevant as suggested by Salmon’s data.

  4. charles
    November 22nd, 2008 at 08:16 | #4

    What your saying ernestine is, as a depositor you will loose your money secretly.

  5. Socrates
    November 22nd, 2008 at 11:51 | #5

    If this is true I find it hard to believe it only applies to Citybank.

    I assume that nobody wants to discuss this in much detail for fear of initiating more fear. But it leads to the obvious question – does anyone know how many banks are actualy insolvent now? I can’t help remembering back to teh early 90s when Westpac was “technically” insolvent. But they kept it afloat by fleecing AMP (and mug investors like myself). The truth only came out years later with Paul Barry’s book.

    In another sense Westpac illustrates the solution – banks can trade their way out of difficulty. But surely there is some obligation for banks to reprot their extent of exposure on these deals? Doesn’t it count as relevant to their share price and therefore something they must report to the stock exchanges?

    Is there any way to estimate, even in aggregate, the likely shortfall in bank liquidity and how many may be insolvent?

  6. Michael of Summer Hill
    November 22nd, 2008 at 11:55 | #6

    John, as the VIX, known as Wall Street’s “fear gauge” keeps on rising, Citigroup managing directors are putting out feelers with the executive recruiter WhiteRock Group looking for work. Maybe they know something we don’t.

  7. November 22nd, 2008 at 12:03 | #7

    Not a cheery Saturday morning message but probably an accurate one.

    The surging US unemployment scares me. The highest since 1992 and growing strongly.

    What will be the second-round effects of people losing their jobs on housing markets which in turn…?

  8. conrad
    November 22nd, 2008 at 14:22 | #8

    I wonder if the EU would really want Switzerland if all they can offer is a disaster, especially when the main countries are not exactly swimming in money themselves, and nor are their own banks likely to be in a great position either. Being (not especially) nice to Iceland is one thing, but Switzerland has 7.5 million people so the cost would be vastly more. Even if Switzerland really wanted to join, I’m sure they could tie them up in bureaucracy for enough years that no-one would have to do anything.

  9. rabee
    November 22nd, 2008 at 14:34 | #9

    Hi John,

    The price of credit default securities for citigroup is a bit higher than Goldman and lower than GE; as far as I can tell from bloomberg, because that information is not public.

    It’s not as bad as Lehman or Bear Stearns.

    But for some reason, it seems to me that private information is being reflected by citi’s share prices but not its default spreads.

    The problem is that the CDS market is not informationaly efficient.

    This low CDS price probably means that there will be a lot of contagion should citi start defaulting.

    If citi fails now neither nationalization nor outright socialism is likely to fix the mess that we’re in. It’ll be back to rabit, mutton, and kangaroo for us here in Australia.

    I say this even though I’m solidly on the optimist side of things and my view has been that this will quickly pass because modern communication will see to it that prices and conditions quickly adjust.

    Obama has an obligation to become engaged in solving these problems. It is simply negligent to maintain this policy vacuum. History will not be kind to him should citigroup fail in this interim period.

    Hank Paulson should be sacked NOW! He let Lehman collapse and last Tuesday’s announcement at least to my ears sounded like he’s going to let citi collapse.

    As for Australia, if the RBA (which has Australia’s best analysts) can smell a whiff of death for citibank, then we should be putting our banks in an incubator now. Especially, the CBA and Macquarie.

    The Australian Government should also be meeting with academic economists right now. There’s a wealth of talent in Australia and its incumbent upon them to be engaged.

  10. carbonsink
    November 22nd, 2008 at 15:02 | #10

    Whoa! Looks like you guys have come over to the dark side.

    Oh well, back to Steve Keen’s blog…

  11. Arjay
    November 22nd, 2008 at 19:29 | #11

    Isn’t funny that just recently Citigroup came to my business offering unsecured credit at a fixed rate of 6.9%.This was a $24,000.00 loan.Have they learnt nothing?When I enquired about the terms in detail,they went cold.Can you trust them?

  12. rog
    November 23rd, 2008 at 06:19 | #12

    Why would you entertain socialism bill broome when the current debacle is clearly due to govt agencies distorting markets?

    Ironically China is seeing the light;

    He even suggested that the government give up pricing regulation and let the market have the final say. “It’s high time we do that and today’s worsening economic situation has partly resulted from incorrect signals due to too much pricing regulation,” said Zhou, who has predicated this time last year that “all Chinese enterprises should be ready to spend a winter period in business.”

  13. Chris Warren
    November 23rd, 2008 at 07:34 | #13

    I agree with rog that governments distort markets but a bit of balance would assist rog.

    The current debacle is not clearly due to government agencies distorting the market. Monopolies, cartels, and capitalist licencing restrictions, plus private debt/credit create far greater distortions than governments.

    The main distortion by Western governments over the long term is a savage restriction on workers wages generally keeping the minimum wage at levels hovering below the poverty line.

    Workers also want less government distortion, and look for the day when the capitalist state simply “withers away”.

    Under proper socialism (market socialism) there is no government distortion and workers are free to set the price of their labour at the level of productivity, and there are no unearned incomes.

    So by all means, lets raille against government distortion, but lets be fair and include all government distortion.

  14. charles
    November 23rd, 2008 at 07:46 | #14

    rabee

    The government has effectively guaranteed all Australian bank deposits, the RBA is willing to provide them with liquidity, what more do you want?

  15. rabee
    November 23rd, 2008 at 09:28 | #15

    Charles,

    If citigroup fails, then it is likely that financial institutions in Australia will be exposed to this failure.

    If the US treasury acts prudently and not ideologically, then citigroup, Goldman, Morgan, and any financial institution bigger than Texas, will not be allowed to fail.

    Now if the RBA (which has the best analysts in Australia) thinks that Hank Paulson is going to teach another bank a lesson in moral hazard, then we should be putting our banks in an incubator.
    Here I’m talking about ownership and the separation of M3/Broad Money generating activities from other businesses (something that Quiggin has advocated).

    My own predisposition is to suppose that if the US saves the financial system from further deterioration, then we should be able to cruise along and the rest of the economy will sort itself out quick smart. In such a case, our banks should be fine and we’ll need to think about whether in the long-run it’s prudent for us to have four giant clones. We will also need to think about how we guarantee the independence of institutions like the RBA, the ACCC, the APRA in times of crisis; and what does independence mean.

    I don’t trust Hank whose main talent seems to be knowing when to sell high and then buy low. He’s acting like he’s shorting the financial market.

  16. Will
    November 23rd, 2008 at 09:29 | #16

    Charles

    The banks need capital as well as liquidity to lend, and capital is what is being destroyed as the banks make losses. Today, without new capital, you can drown the banks in liquidity and they will still not lend (except zero risk-weighted lending back to their own governments) and, for many, they will still be insolvent. Plenty of examples out there today – US, UK, Ireland. The Aussie banks appear to be in better shape, but all banks make significant credit losses in a recession, and these are still to come.

  17. rabee
    November 23rd, 2008 at 09:44 | #17

    Will,

    I’m glad we have a person in underwriting here.

    Could you tell me the effects on a bank of underwriting activity jointly with another bank and that other-bank failed. I understand that certain activities are underwritten by a consortium of banks.

  18. Will
    November 23rd, 2008 at 10:09 | #18

    Rabee

    All syndicated lending, including underwriting, is joint and several, so a bank is never liable for another bank’s obligations towards the borrower. In terms of what’s going on today, however, most underwritings have already been pulled by their banks anyway on the basis of a material adverse change in market conditions. There are still attempts to get some deals done jointly by groups of banks on a best-efforts basis, and I have recently seen some banks walk away from their non-binding commitments to these as their funding base has collapsed. It just leaves the borrowers and the remaining banks to get on with it the best they can.

    BTW, did you get my email?

  19. observa
    November 23rd, 2008 at 21:17 | #19

    ‘Isn’t funny that just recently Citigroup came to my business offering unsecured credit..’
    As I said previously I received an unsolicited ‘gold’ credit card offer in the mail to transfer any balances over at 2.9% for 18 months when cards are generally 20% plus and this when they were already cutting staff.

    Speaking of gold I noticed in The Oz Weekend Biz, the Perth Mint has suspended orders until january due to unprecedented demand for physical gold. There is a shortage world wide and there are apparently big futures contracts to be exercised in Dec on the spot markets which have largely been paper crosses to date. With physical gold prices outstripping the paper market (I just saw a Perth Mint 1oz ‘Gold Nugget’ coin reach $1725 on ebay)there is a clear temptation for big players to stand in the market and demand physical delivery now. We may be about to witness the demise of the world’s reserve fiat currency and with it the rest. The world may be about to demand a return to the gold standard via markets, with central banks powerless to intervene. This sort of scenario is monumental history in the making although Austrians would merely say ‘we told you so’.

  20. observa
    November 23rd, 2008 at 21:28 | #20

    And all I’d say is beware of being a Volgswagen share short in a Porsche world or it could get ugly for you.

  21. rog
    November 24th, 2008 at 11:24 | #21

    Some funds are buying gold, Peter Schiff for one is recommending Perth Mint

  22. smiths
    November 24th, 2008 at 13:14 | #22

    its been like that for months with real world gold price completely disconnected from the ‘market’ price

    and everyone is screaming deflation,

    remember folks, when they zig you zag,

    i reckon there will be steady inflation and gold will have risen dramatically by august 2009

  23. observa
    November 24th, 2008 at 20:46 | #23

    We could easily have deflation and a flight to gold. With many economies and currencies in a state of flux, and investments everywhere as safe as houses, gold can be seen by many as the ultimate safe haven. Certainly Govts and the likes of the IMF throwing vast amounts of fiat money at any and every problem is providing huge impetus for this. Govts are very much part of the problem now because they’re all acting upon Gordon Brown’s maxim- ‘Doing nothing is not an option now.’ As a consequence they’ve all rushed out Bert Kelly’s cow at the rattle of a bucket, when they clearly can’t keep up with the milk supply. There is of course always another option- copping it sweet while money supply deleverages from its past profligacy. In the event they can’t wear short sharp pain for some longer term gain, perhaps the gold market is about to discipline them along those lines anyway.

    When you think about the fiat money bubble first bursting with the awareness of the sub-prime problem, there was a brief respite as it went looking for value in commodities and commodity streams. Well and good for a while but switching all that fiat money to commodities simply created the same problem of quick boom and bust and stay busted as broad deleveraging occurs. That only leaves gold as the haven of last resort. Let’s face it, if you’ve got a lot of fiat dollars internationally, it’s lend it to the West ie US Treasury bonds for next to nix, or turn it into gold. Tough choice and that’s exactly the problem for our Reserve now. Drop interest rates toward zero like the world and watch our dollar fall against the only international solidity left. That’s largely why I’m holding half gold, half cash at bank now. Do your worst Glenn and Co.

  24. Andrew
    November 25th, 2008 at 14:27 | #24

    Ooops…. Citigroup safe. US market stages largest 2 day rally since 1987. How disappointing for those cheering on the beginning of the end.

  25. smiths
    November 25th, 2008 at 15:32 | #25

    citigroup safe? i cant wipe the grin off my face

  26. smiths
    November 26th, 2008 at 13:45 | #26

    the extraordinarily safe citigroup has a leveraged ratio of 56:1

    And they actually understate the truth.
    For instance, besides the $2.1 trillion of assets Citi has ON its balance sheet, it has another $1.2 trillion OFF its balance sheet.

    http://optionarmageddon.ml-implode.com/2008/11/24/leverage-by-the-numbers/

    as i said before andrew, still grinning …

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