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November 30, 2008

Time for the Citi to Sleep

It's easy to believe that Citibank is a tottering tower whose collapse would endanger us all in the canyons below. However, keeping a financial corpse walking further endangers every other financial institution.

When Citi is declared too big to fail, it becomes a more attractive bank to do business with than its competitors who are either not failing or are not too big to fail. Arguably, the competitors who are not failing are better run than Citibank; but now they will lose when they compete with Citi. Some of them, in turn, will fail even though they might have survived if Citi were not in the federal protection program. If they're real big, they'll be bailed out, too. That increases the pressure on the good banks whose only sin is not being too big to fail. Soon we'll be left with only the large losers for banks… or car manufacturers… or insurance companies.

Q: Is this good public policy?

A: The answer's obvious so,

Q: For extra credit, what's the alternative? We don't want the ruins of Citi and AIG and GM crashing down around our heads.

A: If controlled implosions won't take them down, they ought to be carefully demolished.

In general, that's what bankruptcy does. It may be true that the bankruptcy law is inadequate to protect the public interest from the collapse of a giant institution. In that case we need a managed bankruptcy by the Fed or someone else with certain creditors protected more than they would have been in a standard bankruptcy to protect "the system". Obviously who gets such special protection must be crystal clear which it certainly isn't now. As in any bankruptcy, shareholders should come last and will usually get nothing and holders of preferred stock get preferred over the common holders and no one else. Most important, the end result of such a bankruptcy must be to disassemble the threatening wreck, not to apply scaffolding. The bailed-out entity CAN'T be left in a position to compete with and bring down better-managed competitors.

So the wind-down of Citi might mean that depositors are made whole even above the $250K FDIC cap. It may mean that mortgages held by Citi go into a special workout pool. But it CAN'T leave Citi taking new deposits or writing new business. The deposits should go to better banks.

AIG policy holders should be protected. If it's really true that the survival of life as we know it requires holders of AIG-written credit default swaps be protected (I'm not convinced but let's assume it's so), fine. But AIG shouldn't be writing any new insurance policies. If it's true (as I believe it is), that its insurance subsidiary is solvent, then it should simply be sold in one piece or many with due continuing protection for policy holders.

If GM is virtually bankrupt (no reason we shouldn't believe them about that), then let's admit it, pick up the pension liabilities and unemployment liability we have anyway, and arrange the sale of its assets to anyone who'll buy them. Note that we aren't going to buy less cars because GM is gone; we'll just buy them from more efficient manufacturers who managed to survive on their own. Long term we'll probably keep more car manufacturing in the US by letting GM die than by leaving it to damage its competitors.

On the other hand, if GM IS bailed out (as I bet it'll be), then Chrysler and Ford (which might well survive on its own), are in greater danger. Moreover, foreign governments will bail out their manufacturers as well (just as they've done with banks). The bailouts end up canceling each other out AND harming the better competitors AND costing public money.

Some people will say that letting Lehman fail caused the whole current cascade of problems; it's at least as likely that SAVING Bear Stearns either caused its competitor Lehman to fail or made Lehman to cocky to sell itself when it still might have.

Too big to fail SHOULD mean too big for life support. Emergency collateral damage control is sometimes necessary; perpetuating the failed institutions only causes cascading failures among their competitors.

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