Monday, November 24, 2008

Lessons of the Citigroup Bailout, and the Real Purpose of TARP

The U.S. government, as was widely expected, went whole hog today to bail out Citigroup:

Wall Street barreled higher Monday for the second straight session, this time in a relief rally over the government's plan to bail out Citigroup Inc. — a move it hopes will help quiet some of the uncertainty hounding the financial sector and the overall economy. The Dow Jones industrials soared nearly 400 points and the major indexes all jumped more than 4.5 percent.

These bear market rallies are getting quite predictable. Let me start my analysis by reposting a comment I just made at Clusterstock:

China demanded the nationalization of Fannie and Freddie to safeguard its own holdings of agency debt.

The Saudi royal family just played the same card to safeguard its holdings of Citi common stock. It's been obvious for some time that the Paulson TARP is not following the playbook of the Swedish model, which demands that shareholders are wiped out.

I can be a little cryptic sometimes, so here's some exposition. The Fannie and Freddie conservatorship was executed after senior Chinese officials publicly stated that they expected the U.S. government to safeguard China's existing investments in Fannie and Freddie securities. Their implied threat was that China can and will dump its holdings of U.S. dollars and Treasury bonds if its interests are not protected. The Saudi royal family has probably taken note of the newfound power that foreign creditors have over the U.S. and have moved to safeguard their own interests.

Traditional approaches to recpaitalizing banks, using either bankruptcy proceedings or Scandinavian-style equity wipeouts, are clearly not on Secretary Paulson's agenda. Paulson's use of TARP, in contrast to the Scandinavian approach to hitting the reset button on equity shareholders, appears to prolong for as long as possible any destruction of either the shareholders or bondholders of a floundering bank.

The Sovereignty Crunch is in full swing. I'll let you know tomorrow if I do anything to make some money off the Citigroup sucker's rally.