Citigroup woes belie Paulson’s promise of banking ‘stability’

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Many things that Treasury Secretary Henry M. Paulson has said about the credit crunch and financial markets have come back to haunt him.

Now we may be facing a U.S. rescue of Citigroup Inc. -- just one week after Paulson assured the American people that the banking system ‘has been stabilized.’

Citigroup’s shares dived $1.69, or 26.4%, to $4.71 today, leading another meltdown in financial shares, as investors bailed on fears that the sinking economy could torpedo the financial giant.

The plunge in financial issues helped drive the Standard & Poor’s 500 index to an 11-year low.

Citigroup’s stock failed to get any lift from a promise by Saudi prince Alwaleed bin Talal, who owns 4% of the firm, that he would boost his stake because he believes the shares are undervalued.

Once the government started pumping capital into banks last month, many investors assumed that the biggest institutions were at least assured of survival.

But the market clearly has major doubts about Citigroup, even with $25 billion in government capital now on its books.

That was evident today from the credit default swap market, where the annual cost of insuring against default on Citigroup’s bonds rocketed to $390,000 per $10 million of debt, from $240,000 on Tuesday, according to Reuters.

The cost surged even though the Federal Deposit Insurance Corp. has agreed to guarantee U.S. banks’ debts.

Citigroup swaps ‘shouldn’t be trading at these wide levels if in fact there’s a backstop from the Treasury, an implicit guarantee,’ Ricardo Kleinbaum, a credit analyst at BNP Paribas in New York, told Reuters.

One week ago, Paulson was confident that investors were over the worst of their concerns about the banking system.

In an NPR interview, he said: ‘I believe the banking system has been stabilized. No one is asking themselves anymore, is there some major institution that might fail and that we would not be able to do anything about it. So I think that is a positive.’

When the interviewer pressed Paulson on the idea of another major failure, the Treasury chief didn’t flinch.

‘I got to tell you, I think our major institutions have been stabilized. I believe that very strongly,’ he said.