When the Music Stops

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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.” — Charles Prince, CEO, Citigroup
That retroactively
juicy statement appeared in an interview in London’s Financial
Times on July 9. It was immediately picked up and posted all over
the Web. There were many skeptics, but mostly in the hard-money crowd.
Then came August’s collapse of the secondary market for subprime mortgages.
In that market, the music ended abruptly.

Just before
the New York Stock Exchange closed on Friday, September 28, Mr.
Prince announced that Citigroup’s expected earnings will be down
in the third quarter by 60%. But not to worry, he assured the media.

September, this business performed at more normalised levels…While
we cannot predict market conditions or other unforeseeable events
that may affect our businesses, we expect to return to a normal
earnings environment in the fourth quarter.
This was quoted,
with relish, by the Financial Times on October 1. The
FT article added this information
in an audio message on Citi’s website on Wednesday, Mr Prince said:
“We are one of the largest providers of leveraged financing to clients
around the world. When the leveraged loan market severely dislocated
this summer, it had a significant impact on us, resulting in large

Gary Crittenden,
chief financial officer, added: “The market disruption had a severe
impact on our results in Markets and Banking. However, our performance
was below expectations even taking into account turbulent market

The group
said it would record write-downs of about $1.4bn before tax on
funded and unfunded highly leveraged finance commitments. These
totalled $69bn at the end of the second quarter, and $57bn by
the end of the third quarter.

Mr. Prince
was a confident man in late July. Very confident. He was quoted
in an
August 2 article in the International Herald Tribune
see a lot of people on the Street who are scared. We are not scared,”
Prince said during an interview at his office on Park Avenue. “Our
team has been through this before.”

Scared? Not
Mr. Prince. Then, over the next month, Citigroup
lost $1.4 billion
decline “was driven primarily by weak performance in fixed-income
credit-market activities, write-downs in leveraged loan commitments,
and increases in consumer-credit costs,” Chairman and Chief Executive
Charles Prince said in a statement.

Frankly, he
should have been scared back in July, 2006, when he could have unloaded
this junk at face value.

There is a
lesson here: when you can unload future junk at face value, do so.

is not alone. A comparably pessimistic report came from UBS, the
giant Swiss bank. Its loss in the third quarter is expected to be
in the range of $600 million. One
report on UBS reveals the following
world’s largest wealth manager said at the time that the downturn
in credit and equity markets continued into the third quarter and
added it would likely report a drop in second-half profit if turbulent
market conditions continue. In May, UBS closed its hedge fund unit,
Dillon Read Capital Management, after it suffered losses from trading
in the U.S. subprime mortgage market.

The reality
is that the best and the brightest in the financial world entered
into high-risk ventures and then got caught by market realities.
They did not see it coming.

reaction of central bankers was swift.
The Federal Reserve cut
the federal funds rate and the discount window rate by half a percentage
point on September 18. It had cut the discount rate by half a point
in mid-August. The European central bank pumped in close to $500
million worth of euros in mid-August. It had been contemplating
hiking rates above the prevailing 4%. It reversed course and held
rates steady.

The investment
world assumes that central banks can always paper over any liquidity
crisis in the financial markets, and will. But what if the problem
is not liquidity in general but insolvency in a capital market?
It is not that there is not sufficient fiat money in general. The
problem is that in a highly leveraged market there are no buyers
at yesterday’s prices, when yesterday’s prices were the basis of
the existence of a flow of new funds into this market.

When investors
see that a gigantic market that was presumed by all to be liquid
— easy sales without a discount — the money flows in. But then,
one day, there are no more easy sales. Liquidity dries up in a specific
market. Money in general is not the solution. Money injected into
this specific market is required — and not just today, but next
month and next year. These are decades-long mortgage contracts.
Investors thought liquidity was assured until August, 2007. Now
they are gun-shy. They saw what was widely believed to be a liquid
market turn overnight into an illiquid loss-producer that sank the
confident forecasts of huge banks like Citigroup and UBS — the
best and the brightest.


This was not
supposed to happen . . . not yet, anyway. Prince
saw in general what was coming, just not when.

depth of the pools of liquidity is so much larger than it used to
be that a disruptive event now needs to be much more disruptive
than it used to be,” he said.

“At some
point, the disruptive event will be so significant that instead
of liquidity filling in, the liquidity will go the other way.
I don’t think we’re at that point.”

We may not
be at that point, but it is surely coming. When it does, the smart
guys who run the pools of capital will be seen as wise guys looking
for escape hatches.

When liquidity
moves out of a market, the problem is then insolvency, not liquidity.
Liquidity is the product of confidence. A market is liquid because
investors think it is priced rationally by the best and the brightest,
and therefore other investors stand ready to buy a capital asset
when the seller is ready to sell. But then, without warning, other
investors learn that this market had been way overpriced, and so
they move to the sidelines, waiting for blood — or red ink — to
run in the streets. Liquidity is restored at (say) 50% of the previous

Mr. Prince
may be able to retain the confidence of his board of directors.
He may even be making similarly optimistic statements a year from
now, although I doubt it. But the fact is, he went public with his
happy-face statements in July, and the market tossed a cream pie
in his happy face in August. The market can change its mind overnight.
There are no loss-avoiding exit strategies for such events. There
are only write-downs.

The wise guys’
solution was an announcement by the Federal Reserve System that
(1) it would lower short-term interest rates, and (2) it would accept
subprime mortgages as collateral for loans. This is always their
solution. The Federal Reserve has no other solution except the expansion
of fiat money, coupled with optimistic press releases.

The smart
guys believe these press releases. It is astounding, but they do.
They invest in terms of Federal Reserve press releases. They believe
that the stock market is the tail of the Federal Reserve System.
The Fed wags the tail upward or downward in terms of its press releases.

For a time,
the stock market does act as though it is the tail of the Federal
Open Market Committee. But reality is more than perception. Reality
is the profitability of prior allocations of capital. These are
ratified or annulled through free market forces imposed by consumers.
If consumers do not ratify the FED’s press releases, the exit from
specific markets begins. Liquidity in these markets can then be
restored only at lower prices.

As for liquidity,
the Federal Reserve System has expanded the monetary base by less
than 2% per annum ever since Bernanke took over in February, 2006.
By Greenspan’s standards, this is a policy of tight money. It is
disinflationary. Take
a look at the chart.

investors pay little attention to this statistic. They assume from
the headlines about the lower federal funds rate that the Federal
Open Market Committee is expanding the money supply rapidly, which
is not the case. It may be preparing to do this, but as yet, this
has not happened.

It would be
a lovely world if the FOMC were to stick to its policy of minimal
money expansion, and the prices of goods and services would continue
to rise at ever-lower rates. The employment figure would stay low,
and the number of people looking for work and finding it would increase.
The $800 billion trade deficit would disappear, indicating rising
productivity in the United States and an expansion of freedom in
Asian capital markets, leading to increased investment at home rather
than abroad. It would also be wonderful if China’s central bank
would cease inflating at 18% per annum, and the Chinese government
would repeal the price controls on electricity and other government-supplied
goods that it imposed last month. But this combination of pleasant
events is unlikely to the point of absurdity.

Yet it is
this kind of pain-free world that has captured the minds of the
smart guys of the world: the fund managers, multinational bank boards,
and economic forecasters. Theirs is a world in which years of FOMC
inflation, declining thrift, increasing trade deficits, and the
demise of subprime mortgages means nothing significant. The dependence
of the United States government on Chinese central bank purchases
of its debt does not raise red flags to these people. They really
do believe that the possibility of FOMC intervention into one narrow
financial market — the overnight bank loan market — is
sufficient to keep the American economy recession-free and inflation-free
at the same time.

For as long
as America’s investors believe this, they will not prepare an exit
strategy, just as U.S. Treasury officials have not prepared an exit
strategy for the time that China ceases to buy T-bills, let alone
starts selling them. On September 18, the London Telegraph ran a
story of a pair of Chinese officials who warned that the Chinese
central bank would consider selling some of its dollar-reserves.

Fan, an official at the Chinese Academy of Social Sciences, went
even further today, letting it be known that Beijing had the power
to set off a dollar collapse if it chose to do so.

“China has
accumulated a large sum of US dollars. Such a big sum, of which
a considerable portion is in US treasury bonds, contributes a
great deal to maintaining the position of the dollar as a reserve
currency. Russia, Switzerland, and several other countries have
reduced the their dollar holdings.

“China is
unlikely to follow suit as long as the yuan’s exchange rate is
stable against the dollar. The Chinese central bank will be forced
to sell dollars once the yuan appreciated dramatically, which
might lead to a mass depreciation of the dollar,” he told China

course, if China were to sell dollars, the yuan would appreciate even
The smart guys assume that China, an exporting nation, will
not sell dollars, ever. They forget about such things as politicians’
pride, their desire to put Americans in their place, and the universal
desire of investors to get out of a bad investment while there is
still time.
would also cause a spike in US bond yields, hammering the US housing
market and perhaps tipping the economy into recession. It is estimated
that China holds over $900bn in a mix of US bonds.


Today, Americans
who are in bad investments have time to get out. This is because
there is still liquidity for conventional investments. This liquidity
is based on widespread public confidence that assets have been wisely
priced, and that there will be buyers at any time at prices the
same as, or higher than prices today.

The smart
guys of American finance still have the attention of the vast majority
of investors. They continue to praise the Federal Reserve. They
continue to assume that China’s central bank is in the hip pocket
of the U.S. Treasury, that the demand for T-bills is perpetual,
and that foreign central bank holdings of T-bills do not constitute
a foreign policy chip of enormous clout — and an enormous temptation
to use it.

So, the smart
guys and the smart money continue to believe the old phrase, “I’m
from the Federal Reserve, and I’m here to help you.” They continue
to believe that legalized counterfeiting is still productive. They
still believe that timely intervention by the FOMC will keep recession
at bay.

faith is based on a premise: bad money produces rational prices.
This leads to a conclusion: scarce capital that was allocated in
terms of prices that were based on fiat-money will retain its present
value when the new, more stable monetary conditions replace the
older inflationary policy. So, there will be no need to re-price
and reallocate capital when the original fiat money conditions no
longer exist.

I say, take
advantage of the smart guys’ ignorance while you still can.

3, 2007

North [send him mail]
is the author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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