Taxpayers are getting a raw deal in Citigroup's plan to repay its bailout funds, but you wouldn't know it from reading the news. Policymakers are emphasizing the wind-down of the unpopular Troubled Asset Relief Program, and most media outlets are doing the same. But the sloppy structuring of Citi's repayment plan is going to cost the government literally billions of dollars.
The government has two types of investments in Citi: $20 billion in the company's preferred stock, and a 34 percent stake in its common stock. Preferred stock is basically a loan that Citi has to pay back with interest, while each share of common stock gives us partial ownership of the firm. With an interest rate of 8 percent on the preferred stock, the loan is well below market rates, since the government funneled the money to Citi when it was on the verge of collapse last year, and emergency loans like that carry a very high interest rate among investors. But we do at least get paid a return on that investment.
The value of our 34 percent stake in Citi's common stock, by contrast, depends on the stock's trading price. The government bought its roughly one-third stake in February for $25 billion. On Friday, the last trading day before Citi announced plans to repay TARP, the value of that stake had risen to $30.7 billion, for a gain of $5.7 billion. That's a terrible return given the risk taxpayers were taking, but it's still a return.
On Monday, Citi said that in order to have enough money to pay off the government's $20 billion loan, it was going to raise about $20 billion by issuing more shares of common stock. The company's financial health has improved; it can raise money from the private sector and pay back the taxpayers. Sounds great, right? Wrong.
Taxpayers are getting screwed. Citi's stock market value at the end of Friday was roughly $90 billion. If Citi issues another $20 billion in common stock, the company does not magically become more valuable. It's still got the same credit card and mortgage problems it had last week, and the same shaky profit prospects. Since $20 billion is about 22 percent of $90 billion, everybody who owns a stake in Citi's common stock, including the taxpayers, will see the value of their investment decline in value by about 22 percent.
How big a deal is this? Well, 22 percent of the government's $30.7 billion stake is $6.8 billion. That means Citi's plan to "repay" the government actually ends up costing taxpayers money. Not only will our $5.7 billion profit be wiped out, but the value of our common stock investment will actually drop below what we first paid for it in February.
The government doesn't have to let Citi get away with this. The Treasury could just tell the company to keep making its regular interest payments on the $20 billion loan, and pay it off once the company has scored enough profits from its ordinary banking activities. That would take time, but by footing the bill for the loan with profits, rather than through new investors, Citi could pay back one taxpayer investment without destroying the other one. But there are no indications that policymakers are taking the taxpayers' interest seriously--instead, negotiations have centered around how much money Citi must raise from the private sector to qualify as healthy enough to exit TARP.
Why is Citi in such a hurry to pay back its loan? It wants to be able to offer executives bigger bonuses. When Citi pays back TARP, it will no longer be subject to pay czar Ken Feinberg's executive compensation restrictions.
"This is worse than bad," says former bank regulator William Black, who now teaches law and economics at the University of Missouri-Kansas City. "This is undeniable proof that the sole driver for most decision-making is executive compensation.... They're so desperate to avoid those restrictions, they're willing to take steps that actually weaken the company, and certainly weaken the position of the taxpayers."
But you wouldn't guess any of this from reading the Wall Street Journal 's coverage of the situation. The Journal even has the audacity to argue that the government could profit by up to $14 billion on the Citi deal, without explaining how it arrived at that figure, or making any mention of the beating the taxpayers' common stock stake is going to take. As David Enrich and Deborah Solomon write in the Journal:
The government could earn a profit of about $14 billion on its investments in Citigroup once the New York company completes a stock offering and other moves that are part of its deal with regulators.
Nor would you figure out how badly taxpayers are getting treated from reading theWashington Post article  on Citi by David Cho and Binyamin Appelbaum. To their credit, however, Cho and Appelbaum nail down Citi's primary motivation for repaying the loan:
Banks have chafed at some of the conditions placed on the federal rescue money, such as limits on executive pay.... Beginning in 2010, Citigroup no longer will be subject to special federal supervision, including limits on compensation for top executives.
An article by Eric Dash and Andrew Martin in the New York Times  does the Post one better by mentioning that the deal is bad for common-stock shareholders, but still fails to note that the government is one of those shareholders:
"It's terribly negative," said Richard Bove, an analyst at Rochdale Securities. "Management has shown that it is willing to take any action to harm shareholders as long as the executives get paid more money."
Mr. Bove said the payback did nothing to improve Citigroup's overall financial health, nor did it remove the bank entirely from government control. Instead, Citigroup's management had 'ruined' the stock price for the next three or four months, he said."
The points I make above are a critique only of the Obama administration's handling of its investment in Citi, but there are two other problems with the Citi bailout worth mentioning. Back in November 2008, when Citi received its second round of bailout funds, the Bush administration provided it with significantly more money than the company's stock market value at the time. Citi's market value was around $12 billion, and the government provided it with $20 billion. For the price we were willing to pay, we could have bought every share of Citi's common stock and more. Since the company is today worth about $90 billion, taxpayers would have earned a profit of $70 billion on that deal simply by demanding something close to a market rate of return on our investment. Instead, we've been getting paid 8 percent interest.
"We would own Citi. We would get all of the upside," says Black. "If you just thought about it from a conventional finance perspective, we are the fool in the market."
More important, Cit's ability to raise capital in the private sector at all is completely dependent on an implicit guarantee from the federal government. No matter how concerned investors might be about Citi's fundamentals, having watched the government bail out Citi twice last year, they know the government will not let the company fail. That fact eliminates a significant portion of the risk from investing in Citi--if Citi makes great banking decisions and the stock goes up, you make money. If Citi makes terrible choices and teeters on the brink of collapse, an investor knows the government will step in and spare them at least some of the pain. The government should not be giving companies this kind of advantage. It's unfair, and it violates every market-based principle in the book. But we certainly shouldn't give a company this kind of advantage without demanding something very significant in return. Instead, we're going to cut Citi loose from all government restrictions, and pay the bill if the company gets into trouble again.
"We've created the worst conceivable world," says Black. "They can take the most insane risks, and if they succeed, they get to keep all the profits. And if they fail, it's even worse! We bail them out, and we don't make them pay a serious price. They're back in power, completely unrestrained, within a year. And they can now raise the capital because of this implicit guarantee. We have achieved the epitome of crony capitalism."