Two Kinds of Experts

by Gary North
by Gary North

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To prepare yourself mentally and emotionally for this report, I strongly suggest that you spend a few minutes watching the video of a pair of British comedians who zero in on America's subprime mortgage crisis. They have got it, as the Brits say, spot-on.

Whether you take my advice here or not, this crisis is not going to go away soon.

THE PRINCE PREVIOUSLY KNOWN AS CEO

"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." – Charles Prince, CEO, Citigroup

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

In 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.

But 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 write-downs."

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 conditions."

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."

"We 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.

The 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.

Citigroup 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:

The 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.

THAT WAS THEN, THIS IS NOW

I wrote the previous words in the October 2 issue of Reality Check, "When the Music Stops." One month later, Charles Prince resigned, i.e., was unceremoniously fired. He received the axe over the weekend.

If you want to see what the press does to a fallen Wall Street muckety-muck, see the photograph here:

The new CEO of Citigroup, America's largest bank, is a former Goldman Sachs co-chairman and a former Secretary of the Treasury, Robert Rubin. Goldman Sachs has made record profits in recent months. How? By selling short the subprime mortgage bond market.

Prince left his office under a cloud – financial, of course. Nobody gets fired on Wall Street for moral cloud problems. Unlike dark clouds with silver linings, Wall Street clouds are composed entirely of red ink. A Reuters story summarizes the carnage at Citi.

Charles Prince resigned on Sunday as chairman and chief executive of Citigroup Inc, as the bank said it may write off $11 billion of subprime mortgage losses, on top of a $6.5 billion write-down last quarter. . . .

Citigroup said it expects to write down $5 billion to $7 billion after taxes – roughly three or four months of profit – for its $55 billion of exposure to U.S. subprime mortgages.

The write-down equals $8 billion to $11 billion before taxes, and may rise if markets worsen, the largest U.S. bank said. Citigroup's previous $6.5 billion write-down related to subprime mortgages, loan losses and other debt.

The stock market is unforgiving. Citigroup's share price is down by about 35% since June.

So, Citigroup needed to do something to restore confidence. Management fired Mr. Prince. Too late by at least two years. The Board was not entrepreneurial. It did not know when to take action against idiocy.

There are optimistic financial analysts who keep assuring us that the subprime crisis is contained. Yet swollen heads keep rolling. In one week, two heads rolled: Merrill Lynch's Stanley O'Neal, who lost $8 billion of investors' money (so far), and Prince's.

These men were CEO's of the largest bank and largest brokerage firm, respectively. Yet they were both caught up into the mania known as subprime mortgages. They were both like those first-time home buyers in 2005 and 2006, who bought at the top, confident that the housing market would not fall and interest will be complicated. They sang: "But as long as the music is playing, you've got to get up and dance. We're still dancing." They have stopped dancing.

The housing crisis has only begun to escalate. We hear about the decline of new home prices in California, Florida, and Phoenix, but the crisis is now hitting the Midwest, and not just new home prices.

Nevada, California and Florida lead in foreclosures, but the Midwest suffers from the double whammy of a declining housing market and economic performance that lags much of the nation.

"Perhaps Cleveland and Ohio aren't at the top of the list, but that's like standing on the deck of the Titanic and saying we're not taking as much water as we did the last hour," said Mark Wiseman, director of Cuyahoga County's Foreclosure Prevention Program.

"We're still getting over a thousand a month in foreclosure filings and sheriff's sales," Wiseman said.

A recent report measuring the risk of residential mortgage loan delinquencies found that nine of the nation's 10 highest-risk metropolitan areas are in Ohio, Michigan and Indiana, according to First American CoreLogic Inc.

A report from the University of Wisconsin-Milwaukee showed that the number of homeowners with mortgages in Milwaukee increased to 74 percent in 2006, up from 68 percent in 2000. At the same time, the report said the percentage of people paying at least 50 percent of their income on housing has nearly doubled, to 19 percent.

Detroit has wrestled with an abandoned-housing epidemic for four decades. Pointing to an estimated $1 billion in subprime loans issued in Detroit in 2006, Wayne State University law professor John Mogk predicted that nearly everyone in the city will live within 1,000 feet of an abandoned home.

"I drive through the better neighborhoods and I see the signs – overgrown grass, papers piling up on the porch," said Mogk, who specializes in land use planning and development. "These people have left. This is going to continue for another 18 months to 2 years."

Idiots, you say? Indeed. And they did it with investors' money – investors who were also idiots for believing the idiots who put together the deals.

It all looked so easy. It all looked low-risk. The experts said "no problem." The experts were wrong.

When I say "experts," I mean experts in Wall Street finance, not experts in real estate.

In the October 29, 2005 issue of Reality Check, I wrote an article, "Smart Money Begins to Leave American Real Estate." Here are a few highlights.

CNN/MONEY (Oct. 24) ran a story on Tom Barrack. I had never heard of Mr. Barrack, but according to CNN/MONEY, he is "The world's best real estate investor." He has made billion-dollar deals in the United States. Now he is selling. He is moving his investment portfolio off-shore. He is 58 years old. He is 6 feet 3. He is worth a billion dollars.

Arguably the best real estate investor on the planet today, he runs a $25 billion portfolio of trophy assets, from the Raffles hotel chain in Asia to the Aga Khan's former resort in Sardinia to Resorts International, the largest private gaming company in the U.S. Barrack's Colony Capital of Los Angeles, one of the largest private-equity firms devoted solely to real estate, has racked up returns of 21% annually since 1990, handing investors, chiefly pension funds and college endowments, 17% after all fees. Barrack has done deals with Saudi princes, Texas oilmen, a Caribbean dictator – even with Donald Trump.

If I were an envious man, he would make me sick. I'll settle on a little grumbling. . . .

Today Barrack sees signs of the tech bubble mentality in the U.S. real estate market. Too much capital is chasing real estate, he complains, with hedge funds, private-equity groups, and rich investors all bidding up the same properties. "They've driven prices to the point where the yields on high-quality properties are like the returns on bonds, around 5% or 6%," says Barrack. "That's too low." And he sees the bubble deflating soon. Barrack thinks the catalyst will be a trend that few others are talking about, a steep rise in the price of building materials and labor. "Construction costs have spiked 30% in the past nine months," he says. The reasons: shortages of labor and materials like lumber because of the building boom, and increases in the price of oil, needed to produce everything from plastic piping to insulation to shingles.

The slump will show up first in speculative hot spots like Miami and Las Vegas, he says, where condo developers are pre-selling their projects for what look like big profits. When they actually build the units over the next year or two, he predicts, they will end up spending more than the units are now selling for. At that point, says Barrack, the developers will try to raise prices. "But most of these buyers are speculators," he says. "They will either sue the developers to get the original prices or get their deposits back and walk away." The developers will then put the units back on the market, and the glut of vacant condos will drive prices down. "It's the busted deals caused by construction costs that will cause a turn in the market," he predicts.

This is exactly what has happened. Barrack's expert opinion was public knowledge in late 2005. It was published on CNN/MONEY. Mr. O'Neal and Mr. Prince didn't heed the warning. This is evidence that they were experts in putting together financial deals, not experts in real estate. Now they are unemployed experts emeriti. Those who took them seriously are poorer for it.

CONCLUSION

There are real experts and there are Wall Street experts. I suggest that you learn to distinguish between the two.

The assurances about the subprime crisis being contained are not coming from real estate experts. They are coming from people who have built their careers and reputations as permanent bull market advocates. This means that they have built their careers on the Federal Reserve System's ability to sustain the stock market with fiat money. They did well under Greenspan. They will do much less well under Bernanke.

November 8, 2007

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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