Another Crisis, Another Guarantee

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By FLOYD NORRIS

Guarantees that could not be honored thrust the world financial system into its worst crisis since the Great Depression. Will a guarantee by the United States government finally restore confidence in the American financial system?

Only a week after Treasury Secretary Henry M. Paulson Jr. said that the government bailouts had stabilized the most important financial institutions, plunging stock prices forced the government to step in again, both to make another direct investment and to guarantee that losses would be contained from $306 billion in possibly toxic assets on Citigroup’s balance sheet.

The move sent stock prices soaring Monday, with financial stocks leading the way. But those gains did not come close to erasing last week’s losses, and left open the possibility that a renewed sense of concern about the safety of other banks could force still more bailouts in coming weeks.

One lesson may be that it is perilous for the government to even hint that it thinks it is through bailing. That can renew fear about banks, driving down share prices and forcing the government to do the opposite of what it had intended. Since the government has a printing press, it need never be short of dollars. That fact makes this guarantee much more credible than the ones, from bond insurers and other companies, that helped persuade banks and others to take what turned out to be huge risks. Many of those guarantors, it turned out, could not honor their obligations. The government feared financial chaos if there was a string of collapses. Even if Citigroup is the last bailout, the Bush administration, whose rhetoric was perhaps more supportive of free, unhindered markets than was that of any of its predecessors, will leave a trail of socialized risk.

But that trail may not be at an end. The auto companies want billions in bailouts, and other industries are lining up.

And as the nation’s obligations rise into the trillions, at some point investors may begin to question whether a government running huge deficits can also credibly promise that the dollar will not lose its value. Such a worry conceivably could push up the very low interest rates the Treasury now pays to borrow from foreign investors to foot an ever-larger rescue bill.

But those are problems for another day. Now the priority is to keep the financial system from collapsing. The problems of recession, constricted lending markets and falling real estate prices will remain even if everyone concludes the big banks are safe.

In the latest bailout, the government injected an additional $20 billion into Citigroup, on top of the $25 billion it invested a few weeks ago. It also said that it would cover 90 percent of the losses on those $306 billion in securities after Citigroup absorbed the first $29 billion of losses.

The fact that it was necessary to guarantee so many assets — about a sixth of the $2 trillion in assets that Citigroup reported at the end of September — was another indication of both the complexity and the opacity of many of the securities that were created by financial engineers in the great wave of innovation.

The assets in question — described by the government as “loans and securities backed by residential real estate and commercial real estate, and their associated hedges” — must be valued at current market value before the guarantee kicks in, but the government and the bank have yet to agree on those values.

That phrase “associated hedges” captures the fact that Citigroup, like many others, had sought to insure itself against losses with a variety of transactions, including the purchase of insurance, only to learn that the losses were overwhelming those who had promised to pay.

The boom of the first half of this decade will be remembered as a time that financial innovations overwhelmed the capacity of both regulators and banks to assess risk.

The collapses of Bear Stearns and Lehman Brothers, both of which were primarily regulated by the Securities and Exchange Commission, served to focus attention on the agency, which was effectively forced out of that financial soundness regulation area after the Federal Reserve assumed oversight of several of the large companies for which it had been responsible.

But Citigroup had always been under Fed regulation, and the need for repeated bailouts there shows both that the regulation was ineffective and that even after the crisis began, the government underestimated its severity.

At first, the Fed hoped that just making more loans available to banks would reassure markets. Then, as losses mounted, the government tried capital injections. In both cases, investors first showed relief, then grew afraid again.

The newest bailout includes more than the guarantee and the capital injection. It enables Citigroup to treat the guaranteed assets as being relatively safe, thereby improving its apparent capital position.

It could need all the reported capital it can get. David Hendler, an analyst at CreditSights, pointed out that Citigroup’s other assets included $91 billion in credit card receivables, $272 billion in non-United States consumer loans, $163 billion in corporate loans and a net $104 billion in assorted derivatives. Those assets, he wrote, “are not immune to weakness in the overall economy.”

Citigroup was hardly alone in failing to understand the risks it was taking. As financial assets became more and more complex, and harder and harder to value, investors were reassured by the fact that both the bond rating agencies and bank regulators accepted presumably sophisticated models, which showed the risks were small.

Insurance on the assets was issued both by the bond insurers and by others that wrote what were known as credit-default swaps, which amounted to insurance, but were not regulated in the same way. Those who wrote large amounts of such insurance are now in trouble, either negotiating to pay claims for less than promised or, in the case of the American International Group, still in business only because of a government bailout.

In retrospect, perhaps the fact there was a demand for such insurance should have served as a warning that the risks were greater than acknowledged. But at the time, the bond insurance companies thought they would pay few, if any claims, and the A.I.G. executives responsible for writing the swaps told investors they would never suffer any losses.

As Citigroup’s stock was plunging last week, there were also big declines in the shares of the other large banks, including Bank of America and JPMorgan Chase. It remains to be seen whether investors will now be reassured about them as well, or will show the same level of fear that forced the issuance of the latest guarantee.