How AIG and Citi Will Look In a Year

At least one thing is clear about the financial meltdown: We know who the poster children are.

Lehman Brothers and Bear Stearns had their dramatic flameouts, but at this point we’ve survived their demise. Big banks like Wachovia and Washington Mutual wiped out shareholders when they failed, but the financial system managed to absorb the remnants. Dozens of lesser bank failures have seemed minor, by comparison.

But Citigroup and AIG have caused continual stress on the financial system, like an alcoholic father who comes home in worse shape night after night. Several federal interventions have failed to stem the losses at these two firms, yet there’s little choice but to keep propping them up. They’re “too big to fail” yet too tanked to succeed. Still, we can’t get rid of them. They just hang around, spreading gloom like an obnoxious guest who won’t leave.

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These two firms, in fact, have become a barometer for the entire financial bailout. Citi so far has received $45 billion in federal aid, with more on the way, plus government guarantees that back about $250 billion worth of soured assets that nobody will buy. AIG is effectively a ward of the state, with $150 billion in government aid that gives the feds ownership of 80 percent of the company. AIG’s problems are getting worse, too. The beleaguered stock is worth less than a dollar.

It’s an outrage that American taxpayers have had to rescue these two reckless titans. But if you can get over that, an endgame may be coming into view for both of these firms. A year from now, taxpayers might even have begun to get some of their money back.

AIG, the huge insurance firm, is basically being disassembled. The headlines focus on all the federal money it’s soaking up, but the government is essentially acting as a bankruptcy judge overseeing the deliberate sale of AIG’s many assets. Those include several valuable insurance businesses, one of the world’s biggest aircraft-leasing companies, and a welter of smaller businesses. The company is seeking bidders for virtually all of those, so it can pay back the government loans.

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Finance professor Roy Smith of New York University's Stern School of Business suggests that AIG could eventually end up like Beatrice, the food-products conglomerate that buyout firm Kohlberg Kravis Roberts purchased in 1986 for $8.7 billion – the largest leveraged buyout ever at the time. Over the next several years KKR sold off all of the company’s divisions. Some of Beatrice’s old brands, like Wesson, Butterball, Tropicana and Orville Redenbacher, still survive, while other brands – and the parent company - disappeared.

Even in bankruptcy, it can take years to unwind a complex company and sell it off. AIG’s saga will certainly go on for awhile. It will likely get more money for its best assets if it can wait for the economy to recover, instead of selling at fire-sale prices to skittish buyers. So it pays to wait. It will also take years for AIG to execute and sell a huge portfolio of credit-default swaps and mortgage-backed securities – which caused its problems in the first place.

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The pace of progress – if you can call it that – is agonizingly slow. But from the government’s perspective, there’s no hurry. “The government has plenty of money. It can afford to be patient,” says Smith. “Besides, if AIG fell now, the government would probably lose all its original collateral.” It might be five years or more before AIG’s problems are fully resolved. But at some point sooner than that, the firm will stop taking taxpayer money – and start paying it back.

Citigroup’s way forward is murkier, since it's still functioning as a bank more or less. But like AIG, it’s likely to muddle along as a wounded giant for months, even years. The government’s new banking “stress test” will probably find that Citi is in a precarious state, with too little capital on hand to cover mounting losses from foreclosures and other consumer-loan defaults. That may be true at Bank of America, Wells Fargo, and some other big banks as well.

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But that doesn’t mean the government needs to take over banks like Citi, or “nationalize” them. The feds can prop up Citi indefinitely, while slowly forcing it to sell off billions in bad loans and spin off some of its divisions. That's an unsatisfying, even infuriating course of action, but it may do less damage than other methods.

A year from now, Citi will probably still be a mess: Loan defaults will probably keep rising as the recession intensifies, and it will be hard to start selling off those toxic assets until the housing market improves and foreclosures start to decline. But an extended stay at a rehab clinic is better than repeat visits to intensive care. Along the way, Citi will shrink. If it ever becomes small enough to fail, then years of forbearance will have paid off.