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Brad Setser: Follow the Money

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Unintended irony

by Brad Setser
February 25, 2009

From a Tuesday Wall Street Journal story on Citigroup’s efforts to raise common equity:

Citigroup officials hope to persuade private investors that have bought preferred shares — such as the Government of Singapore Investment Corp., Abu Dhabi Investment Authority and Kuwait Investment Authority — to follow the government’s lead in converting some of those stakes into common stock, according to people familiar with the matter.

Emphasis added

There is a difference between a minority stake held the investment arm of a government that doesn’t regulate a bank or backstop the banks’ liabilities and a large stake held by a banks’ home government. But it is striking that none of the “private investors” mentioned in the Wall Street Journal are actually, well, private investors. Sovereign wealth funds are at best a hybrid.

China for example has made it clear that it hopes that the US will protect at least some of its investments from the risk of losses. China’s Vice Premier Wang Qishan told Hank Paulson:

“We hope the US side will . . . guarantee the safety of China’s assets and investments in the US”

He may have just been thinking of the Agencies … but he also may have had a few of China’s other large stakes in mind. The classic response is that the only investment that is guaranteed by the full faith and credit of the United States government is a Treasury bond.

Yet, it increasingly looks like the US is inching toward severely diluting the common equity of a set of banks where sovereign funds have substantial stakes,* if not wiping out the existing equity entirely. That potentially — as Larry Summers warned in a former life — is a foreign policy issue. Summers pondered this topic at last years Davos session on sovereign funds:

[Suppose] the SWF of country A makes an investment in a major bank in country B. The bank gets in big trouble. Is there any control in the world that can assert, that with billions of dollars on the line, their head of state and foreign minister are not going to get involved in the negotiations?

I was never fully convinced highly visible sovereign stakes could be wiped out even if there was an economic case to do so, precisely because of the foreign policy spillovers, which is one of the reasons why I was never convinced sovereign funds should be thought of as just another private player in market. But this crisis keeps spinning in ways that put a lot of different presumptions to the test.

* These stakes often were structured, I think, as convertible bonds that automatically convert into common equity in the future. Most were not straight equity investments.

13 Comments

  • Posted by Larsy

    Hmm, that’s an interesting take: foreign policy considerations are why more drastic measures haven’t been applied to the big banks.

    Perhaps, a solution is to make Citi a joint venture of the governments of China, Kuwait, Singapore, etc. and of course, the U.S.

  • Posted by Twofish

    bsetser: He may have just been thinking of the Agencies … but he also may have had a few of China’s other large stakes in mind.

    I don’t think so. I think he was talking about the value of Treasuries. I don’t get any sense that the Chinese government really expects that the US government would guarantee Chinese holdings in Blackstone, and I haven’t anyone really complain when FDIC handed SAFE a black eye when they seized WaMu. In fact, I suspect that CIC may have been secretly happy that this happened. Similarly, I suspect that Chinese banking authorities aren’t that sad that lots of people lost money from currency transactions, because in order to undertake those transactions they had to work around the banking authorities.

    With Singapore and Kuwait you may have the government scream if the US diluted their common stock, but there really isn’t that much that they can do. With a hypothetical Chinese holding in a major US corporation, China would theoretically be able to retaliate more forcefully, but I think that the US government as a condition for allowing Chinese investment would make a “no bailout” policy quite clear.

    The possibility of foreign and political reaction to losses I don’t think is the big worry. The big worry for me is would wiping out equity do to the financial position of Kuwaiti or Singapore. No one really knew until after Lehman went under, that it would cause problems with AIG. Similarly, because no one quite knows what the Kuwaitis and Singaporeans are invested in, I worry that a surprise nationalization would have some bad and totally unexpected financial result.

  • Posted by Ying

    citi is a global corporation. Why should only the US have the power over its destination? Who are the stakeholders and shareholders of citi?

  • Posted by Twofish

    Larry: Perhaps, a solution is to make Citi a joint venture of the governments of China, Kuwait, Singapore, etc. and of course, the U.S.

    That assumes that anyone in China would want to make such an investment, and I can’t imagine why they would.

    One situation were this *almost* happened, was when CITIC was considering buying Bear-Stearns for some amount of money that was absurd compared to what JPMorgan was willing to pay. Fortunately someone in the Chinese government blocked the deal.

    It was fortunately, because if the Fed had wiped out a Chinese financial company the same week that you had the massive demonstrations in Tibet, the conspiracy theorists and hard core nationalists would have gone beserk, Curiously that possibility is probably why the Chinese government is going to move slowly with any foreign financial acquisitions.

  • Posted by Rien Huizer

    These people have made well informed investment decisions and they deserve no more and no less than enjoyng the fruits of their decisions. Why on earth should a superpower bail out private-looking foreigners?

  • Posted by bsetser

    Ying — AIG is also a global corporation, but right now it is being bailed out solely by America’s taxpayers. Right now the US government is the one that has guaranteed Citi’s liabilities. Given that Citi couldn’t fund itself without that guarantee, the US naturally will have a bit more leverage than others.

    plus, the US has — i think — the lead in regulating citi. again, b/c US taxpayers are the ones on the hook for the downside given the commitment to protect citi’s creditors from losses.

  • Posted by Twofish

    Ying: citi is a global corporation. Why should only the US have the power over its destination?

    If someone else wants to risk tens to hundreds of billions to have a stake in Citi, they can speak up. No one really wants to put money to nationalize a megabank, and the US is only doing so because it doesn’t have much choice.

    Ying: Who are the stakeholders and shareholders of citi?

    That’s not the big question. The big question is how should the shareholders and stakeholders interact with Citi management.

    Bank CEO’s have traditionally been interested in SWF’s because it was felt that they would be hands-off investors. If the US government gets involved, it can’t be hands-off, and if the US government goes hands on, so will the other major holders.

  • Posted by ReformerRay

    One of the important mysteries of why the Officials of the U.S. government continue to prop up domestic banks. None of them are really too big to fail. Their counterparties apparently are too important to allow them to fail. But these counterparties remain unknown. Heck, we don’t even know if the countparties is the real issue. No valid explanation has been provided for Obama continuing Paulson’s policies

  • Posted by Observer

    I would imagine that the Saudi princes who injected capital into Citi can not be too pleased with the mortgage cramdown bills…

  • Posted by Judy Yeo

    brad:

    These stakes often were structured, I think, as convertible bonds that automatically convert into common equity in the future. Most were not straight equity investments.

    Precisely, some were claiming way into late last year that they were still above water in their investments. No doubt it’s been a Big Flood year for some SWFs.

    But honestly do you really think that big private investors are completely helpless, particularly those who “own” lobbyists or interest groups close to the powers that be?

  • Posted by ReformerRay

    Twofish says: “No one really wants to put money to nationalize a megabank, and the US is only doing so because it doesn’t have much choice”

    Not true. Citigroup and AIG can be allowed to fail. The counterargument is that Continential Bank of Chicago took seven years to close down and it was much smaller. Time and trouble is not the issue. Fairness to all parties is the issue.

    Other nations have a legitimate interest in U.S. policy toward mega banks. But they are only one among many interests. What we need is a forthright statement from the Obama administration of what debts they will guarantee and which they will not. I don’t think the U.S. Treasury should guarantee all debts. But some should be.

  • Posted by ReformerRay

    Please permit me to venture off the subject of Japan. The issue of the responsibility of the Federal govenment towards all the claims on the U.S. banks that are in trouble transcends Japan but it includes Japan.

    The federal government is under strong pressure from the bankers to decide
    what to do about AIG and Citigroup. They want a template, a guide to future
    governmental action.

    Continuity with the past should be maintained, where possible. All the
    contracts on the books of these two companies that were entered into as a
    part of the regulated banking system should be treated exactly as the FDIC
    would treat similar contracts when smaller banks go under. Equity holders
    will be wiped out. Bondholders should be treated exactly as they would be
    in the case of a smaller firm. The federal government should use its
    resources to insure that AIG and Citigroup are not too big to fail by
    backstopping them as they have historically treated all banks that fail.

    On the other hand, all those contracts that were developed outside the
    regulated banking system, such as Credit Default Swaps and other derivatives
    are a new entity, not entitled to be treated as a part of the historical
    regulated system. These contracts were deliberately excluded from Federal
    regulation and oversight. They should continue to be outside Federal
    jurisdiction. Those non-regulated contracts that cannot be fulfilled by the
    private parties that own the contracts will not be fulfilled.

    The implications of such a decision would be to allow counterparties to AIG
    and Citigroup in the shadow banking system to lose assets with the demise of
    AIG and Citigroup.

    The main benefit of following this practice would be to eliminate many of
    the toxic assets from the books of banks and other financial institutions.

  • Posted by Ying

    It is certainly not only the American taxpayer on the hook, millions people all around the world are on the hook. The Chinese won’t have the luxury to sit down and enjoy the coupon payment to maintain the standard living. Enormous capital and human investment were idled and wasted from Asia countries.

    For me, it seems that structured finance and globalization boosted by computer technology started to reverse. I can’t see where the growth will come from in the near future.

    There needs to have global rules that govern such mega banks if capitalism wants to survive the downside. I guess most people will opt to scale back finance and let creditors and shareholders to take a hit as RR suggested.

    In my opinion, there also needs industry policies that govern what kinds of products can be produced and what is promoted to produce to save the environment. We can’t leave these decisions entirely for the private sector.

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