The Patient is Dead Part I

President Barack Obama is in the hot seat with the right wing, again, as the U.S. Government now owns 40 percent, give or take, of Citigroup.  Media outlets with various axes to sharpen are calling it a nationalization of the banking system south of the border, creeping socialism, near-communist, New Deal II, yadda yadda yadda.

Let’s see what’s really up with this.  In the Dark Ages of 2003, investment companies and banks were required to keep a reserve of “cash” on hand in proportion to their debt. 

“Cash” was defined as tradable assets and valued by the market with a discount (or haircut), based on the type of asset.  If the ‘cash’ was a Treasury Bill, a very safe investment, the discount was 6%.  If the ‘cash’ was an investment in Sudanese mining stocks, the discount might be 15 percent, or higher.   

The broker would add up all the stocks, bonds and equities they owned, less the discounts and come up with a number.  Let’s call it $1,000 for simple math purposes.  According to the Security and Exchange Commission, they had to keep that $1,000 around, readily available, in the event something went bad.         

The ratio was 12 to 1, meaning the broker or bank had to have $1,000 worth of assets in a drawer somewhere, if they had $12,000 in debt. 

There were rules that broker-dealers had to maintain a certain level of rating with the various (privately owned) rating agencies like S&P, Moody and so on. 

If the broker-dealers got close to the 12 to 1, there were notifications they had to make to the government.  This is only prudent, as there will always be some investments that don’t work out and there has to be some kind of financial cushion to prevent the broker from tanking and taking all the investor’s money down too.

Where things got murky was in how you calculated what an investment company was worth.  Investment companies, to have a wad of money to play with, were usually owned by their own investment banks, which have large lumps of cash around, sitting there, doing very little or invested in very conservative things.

On paper, they’d have a huge market value, as the bank money was counted along with the investment dealer money.  The investment dealer money was significantly more risky, the bank money significantly safer, if something went bad, so there was a fudge factor and a bit of sleight-of-hand in how you calculated the real market value of a broker. 

That market value number became, using the 12 to 1 rule, the amount of money the investment broker could play with and still be legal.  The bigger the wad, the bigger the chance for a huge payback, but also the bigger the risk of losing it all.

The ugly question became:  Who’s value are we calculating?  Is it the holding company?  Is it the broker itself?  How much of that money the investment broker is risking, is actually backed up by something that can be cashed in and paid out if the investments turn out to be floating turds? 

Needless to say the investment holding companies and their hundreds of other companies underneath, had no real idea, as the ‘value’ was often stocks held in each other, again held in a separate company and loaned to another subsidiary, to borrow against, to juggle a big debt somewhere else.  In accounting parlance, it’s called a fuzz job. 

Somewhere in that chain of stocks and bonds, all under the same letterhead of “Citi” or “Lehman Bros.”, but different actual companies, there was a company that could be made to hold the floating turds without affecting the worth of the whole thing at the top of the letterhead. 

Then the tax accountants got into it.  Each company could post losses against profits and move into that whole murk of offshore, onshore, arms-length, closely held, privately held and so on.  The sole objective of the tax accounts was to hide profit and avoid paying taxes.  Profits had to be put somewhere and the Caymans or Bermuda, with their friendly tax laws, were often the location of choice.

Keep in mind, this is before the rules were changed in 2004.

In Part II, we’ll look at the rule changes in 2004.