Monday, November 24, 2008

Citigroup Attempts to Avoid Doom with Government Bailout That Could Set Precedent for Other Plans

Sources: Financial Times, US Agrees Bail-out for Citigroup; New York Times, US Approves Plan to Help Citigroup Cope With Losses; CNN Money, Citigroup Plunges as Bank Mulls Next Move

As another financial giant sat on the brink of failure, federal regulators pondered transitioning to a third phase of government intervention to save the financial industry from ruin. Late Sunday night, the US government announced that it will rescue Citigroup from ultimate failure—by absorbing $306 billion in problematic assets and $20 billion in capital injections.

Federal regulators and Citigroup will guarantee up to $306 billion in residential and commercial real estate loans. The plan requires Citigroup to take on the first $29 billion of losses. The remaining losses will be split 90/10 between the government and Citigroup. The Treasury Department is responsible for the first $5 billion, the FDIC the next $10 billion, and any remaining losses on the government’s shoulders are the responsibility of the Federal Reserve. Citigroup must issue $7 billion in preferred stock to government regulators; the government will also buy $20 billion of preferred stock— which will pay an 8% dividend. Citigroup will halt dividend payments for three years, agree to certain executive compensation restrictions, and will put into place the FDIC’s loan modification plan.

The first two phases of government intervention—buying troubled assets from banks and directly injecting capital into banks—were able to restore investors’ confidence for only a short time before the economic plunge continued. Officials hope this hybrid plan will leave a lasting effect in the market.

President Bush, accompanied by Treasury Secretary Hank Paulson, said that the plan was necessary to keep the economy stable and that it can be used to bail out other institutions in similar distress. Pres. Bush also noted that he has conferred with president-elect Barack Obama on these issues. Obama’s expected appointee for Paulson’s job, Timothy F. Geithner, president of the Federal Reserve Bank of New York, was involved in the weekend’s negotiations.

While Citi’s stock took a beating in the market last week, the cost to insure its loans halved on Monday morning as the risk of default seemed to be lower with the government bailout. With more than $2 trillion in assets, Citigroup is so large and interconnected that other institutions could feel the damage already done.

Questions for Discussion:

1) We have watched regulators unveil several bailout plans in the past few months. Is this the magic one? Is this the solid result of trial-and-error or are there fatal flaws in this plan?

2) At what point do you think the government’s bailout capacities will be maxed? Do these continued bailout plans represent band-aids or are we experiencing a paradigm shift in America’s capitalist system?

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