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Citigroup collapses! Banking Shutdown Possible by Martin D. Weiss, Ph.D. 11-24-08
It pains me deeply to announce that, despite the massive government rescue, yesterday’s collapse of Citigroup could ultimately lead to a shutdown of the global banking system.
For many years, I hoped this would never happen, and I thought we might be able to avoid it.
Indeed, that’s why, my firm, Weiss Research, first began rating the safety of the nation’s banks in the early 1980s, and why I later founded Weiss Ratings, a separate subsidiary dedicated exclusively to safety ratings — on thousands of banks, insurance companies, brokerage firms, mutual funds and stocks.
I subsequently sold the Weiss Ratings subsidiary to Jim Cramer’s organization, TheStreet.com; and today, my former company is called TheStreet.com Ratings. I continue to own and run Weiss Research, Inc., the publisher of Money and Markets. Moreover, Weiss Research continues to review all financial institutions for their safety; and to support that effort, we acquire TheStreet.com’s ratings and data for our analysts.
.
.
.
.
.
And now, here we are, nearing the end of the road with the largest banks of all endangered and with no larger bank that can swallow them up. It’s a day of reckoning that leaves me no choice but to issue this three-part warning:
How will the events unfold? That’s a massively complex question that demands an extremely cautious and thoughtful answer. That’s why, this past August, we devoted a full hour to this question in our “X” List video, naming the most likely candidates for bankruptcy. So let me review its primary conclusions and then take this discussion to the next level.
Most prominent on our August “X” List was Citigroup, America’s second largest banking conglomerate with over $2 trillion in total assets. The bank was already suffering crushing losses in mortgages. But at mid-year, it still had close to $200 billion in other mortgages on its books, denoting the strong possibility of many more to come.
In addition, Citigroup had a massive portfolio of credit cards — 185 million accounts worldwide — that we felt could be the final nail in its coffin. Even before the most recent episode of the global financial crisis, Citigroup’s losses on bad credit cards had surged by 67% from a year earlier. Worse, the number of credit cards 90 days past due was going through the roof, foreshadowing more large losses on the way. All of these weaknesses were detailed in Citigroup’s financial statements. Not detailed, however, was …
The Highly Dangerous Derivatives
Derivatives are bets made mostly with borrowed money. They are bets on interest rates, bets on foreign currencies, bets on stocks, bets on corporate failures, even bets on bets. The bets are placed by banks with each other, banks with brokerage firms, brokers with hedge funds, hedge funds with banks, and more.
They are often high risk. And they are huge. According to the U.S. Comptroller of the Currency (OCC), on June 30, 2008, U.S. commercial banks held $182.1 trillion in notional value (face value) derivatives.1 And, according to the Bank of International Settlements (BIS), which produced a tally six months earlier for the entire world, the global pile-up of derivatives, including institutions in the U.S., Europe and Asia, was more than three times larger — $596 trillion.
That was ten times the gross domestic product of the entire planet … more than 40 times the total amount of mortgages outstanding in the United States … nearly 60 times greater than the already-huge U.S. national debt.
Defenders of derivatives claim that these giant numbers overstate the risk. They argue that most players hedge their bets and don’t have nearly that much money at stake. True. But that isn’t the primary risk these players are taking.
To better understand how all this works, consider a gambler who goes to Las Vegas. He wants to try his luck on the roulette wheel, but he also wants to play it safe. So instead of betting on a few random numbers, he places some bets on the red, some on the black; or some on the even and some on the odd. He rarely wins more than a fraction of what he’s betting, but he rarely loses more than a fraction either. That’s similar to what banks like Citigroup do with derivatives, except for a couple of key differences:
Difference #1. They don’t bet against the house. In fact, there is no house to bet against. Instead, they bet against the equivalent of other players around the table.
Difference #2. Although they do balance their bets, they do not necessarily do so with the same player. So back to the roulette metaphor, if Citigroup bets on the red against one player, it may bet on the black against another player. Overall, its bets are balanced and hedged. But with each individual player, they’re not balanced at all.
Difference #3. As I said, the amounts are huge — millions of times larger than all of the casinos of the world put together.
Now, here are the urgent questions that, as of today, remain largely unanswered:
Question #1. What happens if there is an unexpected collapse?
Question #2. What happens if that collapse is so severe it drives some of the key players into bankruptcy?
Question #3. Most important, what happens if these players can’t pay up on their gambling debts?
This is the question I have asked here in Money and Markets month after month. Almost everyone said it was far-fetched, that I was overstating the risk. Yet, each of the hypothetical events I cited in the above three questions have now taken place in 2008.
First, we witnessed the unexpected collapse of the largest credit market in the world’s largest economy — the U.S. mortgage market.
Second, we witnessed the bankruptcy or near-bankruptcy of three key players in the derivatives market — Bear Stearns, Lehman Brothers and Wachovia Bank.
Third, we also got the first answers to the last question: We saw the threat of a major, systemic meltdown in the entire global banking system.
What Is a Banking Meltdown
And Why Is it Possible?
On October 11, 2008, a single statement hit the international wire services that provides more specific clues:
“Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”
This statement was not the random rant of a gloom-and-doomer on the fringe of society. Nor was it excerpted from a twentieth century history book about the Great Depression. It was the serious, objective assessment announced at a Washington, D.C. press conference by the Managing Director of the International Monetary Fund (IMF).
The unmistakable implication: So many of the world’s largest banks were so close to bankruptcy, the entire banking system was vulnerable to a massive collapse. The primary underlying cause: Derivatives.
The Mafia knows all about systemic meltdowns of gambling networks. In the numbers racket, for example, players place their bets through a bookie, who, in turn is part of an intricate network of bookies. Most of the time, the system works. But if just one big player fails to pay bookie A, that bookie might be forced to renege on bookie B, who, in turn stiffs bookie C, causing a chain reaction of payment failures.
The bookies go bankrupt. The losers lose. And even the winners get nothing. Worst of all, players counting on winnings from one side of their bets to cover losses in offsetting bets are also wiped out. The whole network crumbles — a systemic meltdown.
To avert this kind of a disaster, the Mafia henchmen know exactly what they have to do, and they do it swiftly: If a gambler fails to pay once, he could find himself with broken bones in a dark alley; twice, and he could wind up in cement boots at the bottom of the East River.
Unlike the Mafia, established stock and commodity exchanges, like the NYSE and the Chicago Board of Trade, are entirely legal. But like the Mafia, they understand these dangers and have strict enforcement procedures to prevent them. When you want to purchase 100 shares of Microsoft, for example, you never buy directly from the seller. You must always go through a brokerage firm, which, in turn is a member in good standing of the exchange. The brokerage firm must keep close tabs on all its customers, and the exchange keeps close track of all its member firms. If you can’t come up with the money to pay for your shares, the broker is required to promptly liquidate your securities, literally kicking you out of the game. And if the brokerage firm as a whole runs into financial trouble, it meets a similar fate with the exchange. Very, very swiftly!
Here’s the key: For the most part, the global derivatives market has no brokerage, no exchange, and no equivalent enforcement mechanism. In fact, among the $181.2 trillion in derivative bets held by U.S. banks at mid-year 2008, only $8.2 trillion, or 4.5%, was regulated by an exchange. The balance — $173.9 trillion, or 95.5% — was bets placed directly between buyer and seller (called “over the counter”). And among the $596 trillion in global derivatives tracked by the BIS at year-end 2007, 100% were over the counter. No exchanges. No overarching enforcement mechanism.
This is not just a matter of weak or non-existent regulation. It’s far worse. It’s the equivalent of an undisciplined conglomeration of players gambling on the streets without even a casino to maintain order.
.
.
.
.
.
.
(contd)
For many years, I hoped this would never happen, and I thought we might be able to avoid it.
Indeed, that’s why, my firm, Weiss Research, first began rating the safety of the nation’s banks in the early 1980s, and why I later founded Weiss Ratings, a separate subsidiary dedicated exclusively to safety ratings — on thousands of banks, insurance companies, brokerage firms, mutual funds and stocks.
I subsequently sold the Weiss Ratings subsidiary to Jim Cramer’s organization, TheStreet.com; and today, my former company is called TheStreet.com Ratings. I continue to own and run Weiss Research, Inc., the publisher of Money and Markets. Moreover, Weiss Research continues to review all financial institutions for their safety; and to support that effort, we acquire TheStreet.com’s ratings and data for our analysts.
.
.
.
.
.
And now, here we are, nearing the end of the road with the largest banks of all endangered and with no larger bank that can swallow them up. It’s a day of reckoning that leaves me no choice but to issue this three-part warning:
- Despite the U.S. government’s massive Citigroup bailout, it is going to be difficult for the global banking system to survive the shock to confidence for very long.
- Even if insured depositors do not pull out their funds, uninsured institutional investors are likely to run with their money, threatening to bring the system down.
- And alas, even if you have your money in a safe bank with full FDIC coverage, you could be adversely impacted.
How will the events unfold? That’s a massively complex question that demands an extremely cautious and thoughtful answer. That’s why, this past August, we devoted a full hour to this question in our “X” List video, naming the most likely candidates for bankruptcy. So let me review its primary conclusions and then take this discussion to the next level.
Most prominent on our August “X” List was Citigroup, America’s second largest banking conglomerate with over $2 trillion in total assets. The bank was already suffering crushing losses in mortgages. But at mid-year, it still had close to $200 billion in other mortgages on its books, denoting the strong possibility of many more to come.
In addition, Citigroup had a massive portfolio of credit cards — 185 million accounts worldwide — that we felt could be the final nail in its coffin. Even before the most recent episode of the global financial crisis, Citigroup’s losses on bad credit cards had surged by 67% from a year earlier. Worse, the number of credit cards 90 days past due was going through the roof, foreshadowing more large losses on the way. All of these weaknesses were detailed in Citigroup’s financial statements. Not detailed, however, was …
The Highly Dangerous Derivatives
Derivatives are bets made mostly with borrowed money. They are bets on interest rates, bets on foreign currencies, bets on stocks, bets on corporate failures, even bets on bets. The bets are placed by banks with each other, banks with brokerage firms, brokers with hedge funds, hedge funds with banks, and more.
They are often high risk. And they are huge. According to the U.S. Comptroller of the Currency (OCC), on June 30, 2008, U.S. commercial banks held $182.1 trillion in notional value (face value) derivatives.1 And, according to the Bank of International Settlements (BIS), which produced a tally six months earlier for the entire world, the global pile-up of derivatives, including institutions in the U.S., Europe and Asia, was more than three times larger — $596 trillion.
That was ten times the gross domestic product of the entire planet … more than 40 times the total amount of mortgages outstanding in the United States … nearly 60 times greater than the already-huge U.S. national debt.
Defenders of derivatives claim that these giant numbers overstate the risk. They argue that most players hedge their bets and don’t have nearly that much money at stake. True. But that isn’t the primary risk these players are taking.
To better understand how all this works, consider a gambler who goes to Las Vegas. He wants to try his luck on the roulette wheel, but he also wants to play it safe. So instead of betting on a few random numbers, he places some bets on the red, some on the black; or some on the even and some on the odd. He rarely wins more than a fraction of what he’s betting, but he rarely loses more than a fraction either. That’s similar to what banks like Citigroup do with derivatives, except for a couple of key differences:
Difference #1. They don’t bet against the house. In fact, there is no house to bet against. Instead, they bet against the equivalent of other players around the table.
Difference #2. Although they do balance their bets, they do not necessarily do so with the same player. So back to the roulette metaphor, if Citigroup bets on the red against one player, it may bet on the black against another player. Overall, its bets are balanced and hedged. But with each individual player, they’re not balanced at all.
Difference #3. As I said, the amounts are huge — millions of times larger than all of the casinos of the world put together.
Now, here are the urgent questions that, as of today, remain largely unanswered:
Question #1. What happens if there is an unexpected collapse?
Question #2. What happens if that collapse is so severe it drives some of the key players into bankruptcy?
Question #3. Most important, what happens if these players can’t pay up on their gambling debts?
This is the question I have asked here in Money and Markets month after month. Almost everyone said it was far-fetched, that I was overstating the risk. Yet, each of the hypothetical events I cited in the above three questions have now taken place in 2008.
First, we witnessed the unexpected collapse of the largest credit market in the world’s largest economy — the U.S. mortgage market.
Second, we witnessed the bankruptcy or near-bankruptcy of three key players in the derivatives market — Bear Stearns, Lehman Brothers and Wachovia Bank.
Third, we also got the first answers to the last question: We saw the threat of a major, systemic meltdown in the entire global banking system.
What Is a Banking Meltdown
And Why Is it Possible?
On October 11, 2008, a single statement hit the international wire services that provides more specific clues:
“Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”
This statement was not the random rant of a gloom-and-doomer on the fringe of society. Nor was it excerpted from a twentieth century history book about the Great Depression. It was the serious, objective assessment announced at a Washington, D.C. press conference by the Managing Director of the International Monetary Fund (IMF).
The unmistakable implication: So many of the world’s largest banks were so close to bankruptcy, the entire banking system was vulnerable to a massive collapse. The primary underlying cause: Derivatives.
The Mafia knows all about systemic meltdowns of gambling networks. In the numbers racket, for example, players place their bets through a bookie, who, in turn is part of an intricate network of bookies. Most of the time, the system works. But if just one big player fails to pay bookie A, that bookie might be forced to renege on bookie B, who, in turn stiffs bookie C, causing a chain reaction of payment failures.
The bookies go bankrupt. The losers lose. And even the winners get nothing. Worst of all, players counting on winnings from one side of their bets to cover losses in offsetting bets are also wiped out. The whole network crumbles — a systemic meltdown.
To avert this kind of a disaster, the Mafia henchmen know exactly what they have to do, and they do it swiftly: If a gambler fails to pay once, he could find himself with broken bones in a dark alley; twice, and he could wind up in cement boots at the bottom of the East River.
Unlike the Mafia, established stock and commodity exchanges, like the NYSE and the Chicago Board of Trade, are entirely legal. But like the Mafia, they understand these dangers and have strict enforcement procedures to prevent them. When you want to purchase 100 shares of Microsoft, for example, you never buy directly from the seller. You must always go through a brokerage firm, which, in turn is a member in good standing of the exchange. The brokerage firm must keep close tabs on all its customers, and the exchange keeps close track of all its member firms. If you can’t come up with the money to pay for your shares, the broker is required to promptly liquidate your securities, literally kicking you out of the game. And if the brokerage firm as a whole runs into financial trouble, it meets a similar fate with the exchange. Very, very swiftly!
Here’s the key: For the most part, the global derivatives market has no brokerage, no exchange, and no equivalent enforcement mechanism. In fact, among the $181.2 trillion in derivative bets held by U.S. banks at mid-year 2008, only $8.2 trillion, or 4.5%, was regulated by an exchange. The balance — $173.9 trillion, or 95.5% — was bets placed directly between buyer and seller (called “over the counter”). And among the $596 trillion in global derivatives tracked by the BIS at year-end 2007, 100% were over the counter. No exchanges. No overarching enforcement mechanism.
This is not just a matter of weak or non-existent regulation. It’s far worse. It’s the equivalent of an undisciplined conglomeration of players gambling on the streets without even a casino to maintain order.
.
.
.
.
.
.
(contd)
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