Earlier this week, the Treasury Department organized an unprecedented rescue plan for America's largest banks. The banks, most notably Citigroup but also Bank of America and Wachovia, got into big trouble by sponsoring more than $400 billion worth of "off-balance-sheet" affiliates to do highly speculative deals with borrowed money.
These bank affiliates bought a lot of high-yield assets backed by subprime loans, credit card debt, used car loans, and other risky debt. Now it's not clear what these investments are worth.
Citigroup's affiliates have exposure totaling at least $80 billion. The Treasury persuaded several other banks to put up a huge pool of capital that will promise to buy securities that markets may not want, in order to keep market confidence (and bank balance sheets) from collapsing. In effect, the Treasury just added another layer to what may be a house of cards.
The Treasury made sure to leak details of the plan over the weekend, presumably to offset the grim news of Citigroup's quarterly report on Monday, which showed a 57 percent drop in earnings. Officials familiar with the plan say one purpose is to prevent the banks from having to mark down the value of assets in a depressed market, which would further weaken their balance sheets.
Nobody knows whether this plan will work, since at the end of the daisy chain somebody has to be willing to buy debt partly backed by assets that may never pay off. The Treasury is gambling that if a big enough pool of money is organized, markets that panicked will begin functioning normally again. Bad debt and good debt will be sorted out and life will go on.
It sure is nice to have a friend at the Treasury.
Because no public bailout is involved, Treasury officials described their scheme as a "private sector solution." But that's a hoot. Other banks, which had not made the same reckless bets as Citigroup and a few others, were not exactly lined up to put their capital at risk to save Citi's bacon.
Markets clearly failed. If the government had not intervened, America's largest banks could have gotten into dire straits - and still may - because it is possible that markets are accurately downgrading the value of these dubious securities and that worse losses are still to come.
Investors remain skeptical. The stock market has lost ground, and Citigroup stock has taken a beating.
Who are these nice people at the Treasury who say they believe in free markets, but spent the past month arm-twisting other banks to mount this government-induced rescue of Citigroup? The Treasury secretary is Hank Paulson, who served as a senior executive at Goldman Sachs with Robert Rubin, currently chairman of the executive committee of none other than Citigroup. Several other senior Treasury officials are alums of Goldman Sachs where they were associates of Rubin, Paulson or both. Very clubby.
So, consider: If you lose your job to outsourcing or your pension plan to an engineered company bankruptcy or your health coverage to a corporate takeover or your home to a subprime loan shark, hey - that's the free market working and the free market makes America great. Tough break.
But if you are Citigroup, and you just squandered billions of depositors' money on speculative bets that went bad, the whole economy will tank if you fail and the government will rush to your rescue.
Call me old fashioned, but the idea that a big bank can have "off-balance-sheet" deals reeks of wrongdoing. Banks are government-chartered, government-examined, and most deposits are government-insured.
The purpose of a balance sheet is to show all assets and liabilities. Why should a bank be permitted to create an affiliate whose main function is to extract fees and disguise risks? It's shades of Enron.
Citigroup invented this strategy in the late 1980s, according to the Wall Street Journal. The bankers who devised the scheme later founded their own company, exquisitely named Gordian Knot Ltd., whose Sigma Finance investment vehicle is now on the hook for over $50 billion in risky assets.
The same government that undertook this rescue scheme should act to prevent banks from playing these kinds of speculative games. But Paulson, since he took office last year, has been leading a crusade for less regulation.
If the public puts up with this double standard, shame on us.
Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos.
© 2007 The New York Times Company