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Why are US policy makers so desperately trying to prop up the banks instead of allowing them to fail (gracefully). Is it because it would cost too much to cover federally insured deposits?

I came across a financial statement for Citigroup, and it contains an answer to a question I posed some time ago:

• What is the problem with letting all of the failing investment firms fail, with the government guaranteeing all depositors of any size?

The answer appears to be, "There would be no problem, at least insofar as guaranteeing depositors." Here’s why.

The deposits in Citgroup as of December 31, 2008 (in millions):

Non-interest-bearing deposits in U.S. offices                          $ 60,070
Interest-bearing deposits in U.S. offices                                 $229,906
Non-interest-bearing deposits in offices outside the U.S.         37,412
Interest-bearing deposits in offices outside the U.S.              446,797

Total deposits                                                                         $774,185

What strikes one immediately is that only a minority of deposits are interest-bearing deposits in U.S. banks ($229.9 billion). I believe that these are the only deposits covered by federal insurance. If we include checking account (non-interest bearing) deposits, the total that the U.S. would need to guarantee is $290 billion. Deposits in banks outside the U.S. should not reasonably be the responsibility of U.S. taxpayers.

Taking the larger number, how much might the U.S. be on the hook for if it allowed the bank to fail, or took over the good assets and the deposits, wiped out common and preferred shareholders, and allowed bondholders to deal with the rest?

A quick look suggests that the government would not need to put in any substantial amount of money. On a book basis, total assets exceed total liabilities by $150.7 billion. Long-term debt (to bondholders) equals $359.6 billion. Together, net assets plus long-term debt equals $510 billion. This amounts to 176% of U.S. deposits. It is equal to two-thirds of all worldwide deposits.

Citgroup’s loan and investment portfolio is over $900 billion dollars. Although it will be subject to substantial writedowns over the coming year, its realizable value plus the $510 billion cushion of bondholder and shareholder equity seems easily more than is needed to cover all worldwide deposits of all types ($774 billion).

Even if the U.S. had to cover some fraction of U.S. deposits, each 10% of coverage would cost $29 billion.

Consider what Citgroup has already cost the US government (and taxpayers):

• The government has backed $306 billion of Citigroup Inc. securities.  It has not yet had to make good on any of the guarantees, but it will be responsible for 90% of losses on $306 billion of mortgages on residential and commercial mortgages. Potential losses on these are mounting weekly as prices of homes and commercial properties decline.
• It has put $30 billion into the bank’s capital base, by purchasing preferred shares.   Source

Informed analysts all think the price tag is of trying to keep this and other banks from failing is going to rise substantially. Letting them fail gracefully, by a plan such as that proposed by Willem Buiter, or by any restructuring plan the wiped out shareholder equity and forced bondholders to cover the remaining losses, would most likely cost the government (taxpayers) nothing.

As commentators are increasingly loudly explaining, restructuring the banks will put the banks on a solid footing and give them the capacity to make the loans that are the supposed objective of government bailout efforts — all of which have failed to accomplish this objective at great cost to the taxpayer.