My take on the latest Citigroup bailout

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The big news other than GDP falling off a cliff is the confirmation that the Obama Administration is going to bail out Citigroup for a third time.  The market reaction this morning was quite negative, causing index futures to sell off even before the GDP number hit the tape.  Citigroup itself dropped as much as 50% in pre-trading.  Why?  Here’s my take.

Citigroup is a troubled financial institution that would be seized by the FDIC if it were a small institution or that would be forced into the hands of another company if it were a large institution.  However, it is neither.  Citigroup is a colossus that spans the globe with its tentacles in everything.  Therefore, Citi receives special treatment.

Now, if Citi were small, shareholders would be wiped out and receive nothing as the FDIC grabbed its assets and sold them off like it has done with some 20-odd institutions to date during the crisis.  If Citi were large, like Wachovia, it might be forced into the hands of another large institution, with shareholders getting pennies on the dollar.  Effectively, they would be wiped out.  However, everyone knows that neither of these options were available, so Citigroup’s share price was artificially inflated by a belief that the organization would benefit in some way by government intervention.

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The government has intervened.  However, it is now crystal clear that shareholders will not benefit. They will either be diluted by government ownership or they will be wiped out through eventual nationalization — an option still denied by the Obama Administration in spite of the facts.  The shares had benefited from uncertainty because Citigroup shares are really just  options on a government bailout.  Now that the uncertainty has diminished, those options are worth significantly less.

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As to policy, one should be very disappointed.  In my view, the market has sold off largely because the ad hoc bailout policies initiated by Hank Paulson under President Bush have been continued under President Obama.  This makes investment in any financial services industry company difficult.  

Will the government pony up more funds?  Will they nationalize?  Will they seize the assets?  Will shareholders be wiped out? Will bondholders take a haircut?  Each new decision made by the U.S.  Government provides zero clarity on all these issues.  The only thing that is clear is that taxpayer money will continue to be used to prop up troubled institutions for the forseeable future.

In such an environment, one is well-advised to stay away from shares in the financial sector. Investors are beginning to understand this logic.  This is why shares are selling off across the board.

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