After digging deeper into the practices of Citigroup (NYSE:C) which led to them being required to be bailed out by taxpayers, the Financial Crisis Inquiry Commission (FCIC) has targeted what are called ‘liquidity puts,’ which are guarantees put in place for investors in debt securities.
The conclusion of the panel may be that the liquidity puts were the major cause of the fall of Citigroup.
A liquidity put is a guarantee for traders which allows them to sell the debt securities they acquired back to the bank if the credit markets freeze, which is of course what exactly happened.
Normally liquidity puts are never needed, and so while being guarantees, are usually used as a marketing tool which adds safety to the investment for the one buying them. Under healthy economic conditions they are never thought of having to be used by those offering them as incentives. Citigroup was wrong, and part of that was related to not understanding the depth of the problems hitting the markets.
As the financial markets collapsed, so did the value of the CDOs, which Citigroup ultimately had to buy back at 33 cents on the dollar, which the Crisis Inquiry is starting to believe was what caused their collapse.
If you’ve followed the AIG crisis, this is the same type of practice which led to their downfall, where their insurance against the default of CDOs led to enormous losses.
The bottom line in all of this is Citigroup and other financial institutions didn’t understand what these guarantees meant and the real risk involved in them, and so happily went along with using them as a marketing tool, not knowing they were setting themselves up for failure.
In the end, Citigroup traders believed the puts were almost completely safe and so the bank didn’t list them on their balance sheets, consequently there was very little capital set aside in case of defaults of any significant size, which in fact is what happened.
