“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Former Citigroup CEO Charles Prince, July 2007

The Carnoustie effect is defined as the degree of mental and psychic shock experienced on collision with reality by those whose expectations are founded on false assumptions. This also sounds familiar with the lax interest policy that ignores bubbles, demonstrating a classic reality check for Citigroup.

Citigroup had been acquiring more short-term funding and rolling over short-term liquidity daily. Imagine you have to refinance 20% of your mortgage every day. “But when the music stops, in terms of liquidity, things are complicated”, especially if bursting of bubble affects banking sector triggering a credit crunch.

This week the margins eroded the capital base of Citigroup and equity shrank, and if they cannot get a capital infusion they will be forced to sell assets at fire sale prices. This loss spiral will eventually drive Citigroup hanging on to others, and taking positions that may drag others down. It is important to understand that the capital and leverage ratios do not capture the aspect of overnight borrowing.

Making matters worse, Citigroup announced that it would reclassify $80 billion in assets into categories that are not marked to market. The evident hitch here is that it gives the impression that the board is trying to mask how dire the books are, playing the role of Leonardo Di Caprio in the movie “Catch Me if You Can”.

Unfortunately, any other financial institution will be cautious about making a deal with Citigroup until it can be assured that the bank’s books are done exploding, focusing on maturity mismatch and market liquidity of assets. That ultimately means providing clarity to those Level 2 and Level 3 assets. Until it does so, Citigroup just looks like a ticking time bomb that has a detonating mechanism that can be set to go off any time soon.