Citigroup, the Bailout, and the Wrath of Moral Hazards

(H/T to Michelle Malkin) To no one's surprise, negotiations are already under way between the Feds and Citigroup for yet another bailout.

Citigroup Inc. will probably get rescued by the U.S. government after a crisis in confidence erased half its stock-market value in three days, investors and analysts said.

Citigroup has more than $2 trillion of assets, dwarfing companies such as American International Group Inc. that got U.S. support this year. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke may favor a rescue to avoid the chaotic aftermath of Lehman Brothers Holdings Inc.’s bankruptcy in September.

“There is no question that Citi is in the category of ‘too big to fail,’” said Michael Holland, chairman and founder of Holland & Co. in New York, which oversees $4 billion. “There is a commitment from this administration and the next to do what it takes to save Citi.”

…Including a $25 billion capital injection from the U.S. Treasury under the $700 billion Troubled Asset Relief Program, the company has at least $50 billion of capital above the amount required by regulators to qualify as “well capitalized.” Capital is the cushion banks must keep to absorb losses and protect depositors.

Deutsche Bank AG analyst Mike Mayo wrote in a report today that the bank’s $25 billion of reserves, when combined with other resources, “should be enough to cover estimated cumulative losses of $50 billion on loans.’” Mayo rates the stock “hold” and has a $9 price target.“With Citi being as big as they are, the government will make a special case and step in and find another reason to dispose of more TARP funds,” said Matt McCormick, a portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel in Cincinnati, which manages about $2.9 billion and doesn’t own Citigroup stock or debt.

According to the Wall Street Journal, Citigroup is looking at a number of options including selling off assets and breaking up the company. Furthermore, the CEO, Vikram Pandit, characterized Citigroup's business model as excellent and blamed their problems on fear mongering by their competitors. Frankly, if he is characterizing things correctly, Citigroup shouldn't be in need of a bailout.

The problem here, as I see it, is that a government bailout became a part of the company's myriad of options immediately. When a company is struggling there are many options, and none of them are pleasant. Companies can downsize, sell assets, borrow (if someone will lend), or issue more stock. The first two will make the company less powerful. The fourth will make each shareholder's shares less valuable. That's the way it is supposed to be. When your company gets in trouble, you do unpleasant things to get it out of trouble. This painful process is all part of vibrant capitalistic system. That's because the pain associated with turning around a company that is upside down like Citigroup keeps the players from making that are too risky or face winding up in such a situation.

The moment that the system takes away the pain, we have what is known as moral hazard, a concept I have written about often.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his or her car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

Going to Capitol Hill, eating crow, and then begging for tax payer money is a lot less painful than having to watch the company you rule over get halved, or worse having the same thing happen with your investment. (as in when a company issues a lot more shares)

What this nonstop bailout palooza has created is an environment where a bailout is now one of several legitimate options for any company in trouble. What sorts of behaviors will this create? First, companies will put off making tough decisions since they know that if all else fails they will get a bailout. They will pay less attention to their leverage. They will take more risks. They will do all those things that everyone does when the pain associated with failure is minimized. Moral hazard is not merely a concept to be learned in advanced economics. It is a state of mind that breeds the worst kind of behavior from the players in our capitalistic system. It's exactly the environment that we now have with bailout palooza.