Issue was not whether to rescue Citi, but how

By Mark Felsenthal - Analysis

WASHINGTON (Reuters) - For U.S. officials, it was not a question of whether to rescue Citigroup (C.N), but on what terms.

If ever there was an institution too big to fail, it was Citi, government officials believed. And if ever there was time when the financial system was too delicate to face another major shock, it was now, with the economy likely headed into a contraction and stock markets in steep decline.

Those considerations led the Federal Reserve, U.S. Treasury and Federal Deposit Insurance Corp to take on much of the risk of losses on about $306 billion of Citi's risky assets, a source involved in the discussions said.

Citigroup was particularly hard hit by the downturn.

To some extent the bank exposed itself with a failed bid to buy Wachovia WB.N weeks earlier. The Wachovia deal had been a chance to strengthen Citi in critical areas -- the deposit base and its commercial banking operation.

But when Wells Fargo snatched Wachovia from Citi's grasp with a better offer, some of the New York institution's weaknesses became more visible to testy markets. Pressure on Citi's stock price last week stepped up as scrutiny of their management and their business model heightened.

Citi was underperforming peers in a dismal market, and when stock markets plunged on Wednesday and Thursday, led by financials, a run on the institution seemed incipient. The bank appealed to the government for help.

Talks involving Citi and officials from the Federal Reserve, the Treasury Department and bank regulators picked up over the weekend.

By Saturday, government officials were in agreement that they needed to provide relief, but had to agree on what terms, the source, who spoke on condition of anonymity, said.

A generic statement of support would fail the laugh test, but a heavy-handed intervention, as was done with bailout of American International Group, was also unattractive.

Similarly, terms of any financial support would have to find a balance between overly generous and harshly punitive.

The Citi rescue, which provided the bank with a backstop for what it saw as a critical segment of distressed assets, was just one of the latest government efforts to restore some calm to markets.

On Tuesday, the Fed announced two new measures -- one aimed at restoring credit flows to consumers and small businesses, and the other targeted at lowering mortgage rates.

In some sense, a new program to buy up $600 billion of mortgage-enterprise debt and securities was born of a need to correct the unintended ill consequences of an earlier financial rescue decision.

After officials took over operation of government-sponsored mortgage finance companies Fannie Mae and Freddie Mac, mortgage rates had begun to drop. That raised hopes that lower borrowing costs could revive appetite for homebuying, which is seen by many as critical to economic recovery.