The big news today is the plan to bail out Citigroup by the FDIC and Treasury. You can read all about this elsewhere. There are some broader points, though, which I haven't seen too much discussion.
There's a big question in my mind why the Citiempire went down to begin with. It's pretty easy to see why Bear Sterns and Lehman fell. Both were borrowing short to lend long with a great deal of leverage, so their entire business model depends on trust. With the stock market as a barometer of that, their tangible value starts being a function of the stock value, and when the stock goes down, people have less trust, so the stock is worth less, and so on. Morgan Stanley and Goldman Sachs avoided these problems by becoming associated with bank deposits which lowered the counterparty risk of dealing with these companies.
AIG's bust is pretty straightforward as well--bad risk managment related to CDOs and credit default swaps caused counterparties to demand huge payments as collateral, which AIG could not provide. Buffett's Berkshire is currently going through similar problems related to their investments in long-long term S&P index puts (who are the buyers?), for which Goldman apparently wants some collateral, and also concerns of losing investment-grade ratings for debt.
Citigroup is a tougher case. On the face of it, they have healthy free cash flows (not as nice as say Banco Santander's, but better than WaMu). Sure, many of their assets are toxic, and it's tough to figure out which ones are, but they certainly have the cash to handle day-to-day transactions in ways the Investment Banks could not. Insured deposits and lines of credit with the Fed give it a much stronger lifeline. Somehow, the crisis in confidence was enough to sink the company.
Brad DeLong's explanation is the best I've heard. Bad distributions on risk models, exploding risk premiums, and general bank concerns sank the company.
(One thing to keep in mind about bad risk modeling is state dependency. That is, money isn't worth as much in different states of the world (which is why no one will buy insurance against nuclear winter). Ideally, this would be a reason for banks to make sure they have enough to survive in times of crisis--as with Rajan's proposal of financial crisis insurance. That proposal is a pretty clever way of making sure banks have capital in times of need, without needing to tie up cash in boom times when agency problems (ie, Chuck Prince) are pushing to make quick cash with that money. Plenty of people call for more regulation in financial markets, seeing it as the same sort of quantity-based good as infrastructure or oil. Banks are very, very good at regulatory arbitrage and regulatory capture, so short of China or India style regulation, there will still be bank crises, and the more interesting stuff is how to design institutions which are incentive-compatible between regulators and banks.)
So it's tough to detail exactly what's wrong with Citibank. The general problem common to all the minor problems, however, relates to the basic structure of the company. Citi was conceived as a "global universal bank" where you go for all banking needs. The critics said that this would lead to all sorts of sprawl and size issues, and they were right. Citi was incapable of judging or handling risks, insulated by the notion that it was a "safe, big" bank. Pandit has tried to keep the broader model alive, but the collapse of his old Hedge Fund under Citi's care shows that it's difficult to integrate many business segments with different risk appetites under one roof. There's a lot of pressure now to sell off Citi into manageable pieces. This is a problem for Citi and also those "Citi-clones"--UBS maybe, perhaps even JPMorgan. Internationally, you have banks like ICICI. Some of these are really too big to fail, and are maybe even solvent. But they face severe management problems.
But whatever the problems with any of the too big to fail banks, the Treasury can print out enough money to keep them afloat longer. How much longer can they keep doing that? With long-term entitlements and debt spending up to tens of trillions, huge deficits and stimulus plans pushing those further, more and more bank guarantees and bailouts, how much longer can the government keep up their credit rating? Right now, they benefit from the flight to safety. Eventually, this will stop, as will continued purchases of Treasuries by foreign governments. Facing higher costs of capital would destroy the financing capacity of the Federal Government to be the ultimate IMF for the American economy, bail out firms, and would crimp monetary and fiscal tools to combat recessions. On top of all the other problems in ensuring normal governance with expensive rather than cheap debt.
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