The failure of the slice and dice "liquidity" modle

Nicole Gelinas:

SUNDAY's Citigroup bailout marks the end of an era. Citi was the global emblem of American financial capitalism. But now the world sees Citigroup and its New York home base as emblems of failure.

Yet markets are working to get us through this crisis. The government will continue to cushion the full impact of market forces - but it must continue to let markets work.

Citigroup was in acute trouble until the bailout saved it. The deal will let Citi stay Citi, with its current management. The government (acting through the Fed, the Treasury and the FDIC) will take responsibility for up to $250 billion in future losses on Citi's mortgage- and other asset-related loan and bond portfolios. In exchange, the feds get a bigger stake in the bank, plus ongoing management and compensation oversight.

What the world doesn't see is that what failed wasn't capitalism but the firms that naively adopted the financial model in vogue for the last decade: the idea that any loan, bond or other bank asset could be sliced up and turned into an instantly liquid, priceable and tradeable security, with all its risks engineered away.

Citigroup and the rest of the financial-industry giants embraced that business model. Its abject failure now leaves much of the rest of the industry dependent on the government's explicit willingness to prop them up.

Yet Citi's fate is a testament to the power of markets.

Starting 13 months ago, Citigroup and other banks, in concert with the government, began an effort to hide the very real losses that were starting to seep through the industry's balance sheets and toward the government's books. Their efforts started with the October 2007 idea to sequester what was thought to be the industry's $100 billion or so in bad assets in an "off-balance-sheet vehicle" jointly owned by three big banks.

It didn't, and couldn't, work. Despite the soothing words, the markets (themselves recovering from years of irrationality) knew that something was very rotten at companies like Bear Stearns, Lehman Brothers, Merrill Lynch - and, finally, Citi.

As financial and government executives kept insisting that all was under control, the markets became more and more insistent - forcing firm after firm to capitulate to reality.

The government was the last such entity to capitulate. Even last month, it still thought that, by handing out capital to a big group of banks and guaranteeing some bank debt - it could hide which of the biggest surviving firms were actually desperate for the money.

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It's a dismal solution. The government may have to shoulder bigger losses beyond the $250 billion. And shareholders certainly aren't shouldering all their real losses. But practically speaking, it's the best free-marketeers will get - and it shows the markets that they were correct.

That is: The world's biggest financial and political powers couldn't hide the truth. The markets, despite their severely weakened state, forced the government's hand.

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What we are finding is that these instruments in many cases produced the opposite of liquidity and in the process exaggerated the losses of the underlying asset. They added increased leverage to an already leveraged transaction and when the market turned down they accelerated that decline.

As I have argued before there was also a profound failure of risk analysis associated with these instruments. If that is not cured, these bailouts will be like dumping money down a sinkhole.