by John Bougearel – author of Riding the Storm Out

cds+for+citi.gifHmmm. What gives here? The above chart illustrated the heightened tensions in the CDS market for Citigroup and to a lesser extent BAC and WFC. The CDS chart was created by former IMF chief economist Simon Johnson.

Upon close examination you will see that fears of a Citigroup default have been growing immensely since Obama’s election. In fact, they have doubled from roughly 300 bps to over 600 bps by early March. After CEO Pandit announced how wonderful profits and revs were in the first two months on the year, the CDS market for Citi fell back to 500 bps momentarily. But even as the braod stock market has climbed out of its March hole by roughly 25%, and the financial sector by more than 40%, the CDS market for Citi moved north of 600 bps by end of Q1 09.

Why is this happening to Citi. Well in part, JOhnson believes it might be because of last week’s “proposed  legislation for a “resolution authority” that would effectively permit the government to liquidate or restructure large systemic financial institutions. This authority offers a clear path to recapitalize institutions without using taxpayer money.” If the taxpayers aren’t going to recap Citi, then surely it must be the unsecured creditors are at risk of a substantial haircut in the event of a restructuring. According to Johnson, there is about a one in three chance a govt takeover of CIti will take place in the next five years. Of course the risk would surface much sooner than that.

Johnson expounds on the scenario if a govt takeover were to happen: “Imagine what happens when these powers are passed. The U.S. Treasury and FDIC would immediately have the tools need to walk into America’s largest financial institutions, such as Citibank or Bank of America, and liquidate them, or rewrite their contracts and capital structures. Such powers are clearly useful: if the banks are undercapitalized, and private money is not available, then the government could force creditors to swap claims into equity, thus instantly recapitalizing the banks while avoiding use of taxpayer funds. With such steps, the problem of moral hazard, where creditors to banks are bailed out by taxpayers, would at once be forgotten.”

Can you imagine that? Taxpayer prayers would be finally answered. But, in the meantime, don’t forget to say your prayers, cuz there ain’t no miracles on 34th street yet!

Johsno adds that “if they plan to use it [resolution authority] soon, they need to pass this legislation quickly. There is good logic behind requiring creditors to bear part of the cost of restructuring, but we can’t afford to have this hanging over credit markets for months to come. Once passed, the new authority should be used. There is no point in incurring the political and financial costs of passing this legislation now unless it is really needed.”

Very well summarized, Mr. Johnson!