Government gambling on Citi?

There has been lots of talk about whether the U.S. struck a good deal on behalf of taxpayers when it agreed to yet another intervention to prop up Citi. A column in the Financial Times offers an interesting analogy: The U.S. has effectively sold a put option on Citi. In return for the premium income (represented by the hefty dividends on the preferred shares it has purchased), it has accepted exposure on Citi's troubled assets portfolio. If the portfolio declines by about 10 percent, Uncle Sam is on the hook for 90 percent of the losses. For Citi, this is a hedge, they pay for insurance protection.

Normally, if you sell a put, you collect the premium and pray the value of the traded entity stays above the strike price until the expiration date. The problem here is that the expiration date seems to be open ended. A bigger problem of course is that in the near future you would have to think it plausible that the assets being protected could easily decline by 10 percent. Here we get into a valuation mess. How are these securities going to be valued? At fair value? If the losses look enormous, you have to wonder if the bank is incented to take aggressive losses, knowing it has insurance. It's very unclear how all this will play out.

Long-term of course, this could work out well for taxpayers. If the bank can get its act together, the preferred shares may rise. If the common shares zoom past $10.75, taxpayers make out okay, given that the government hold warrants to buy $2.7 billion of common at that price. But frankly, $10.75 seems like a long ways away.

Of course, most people consider put selling gambling. - Jim