When the Music Stops

“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

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.

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.

This was quoted, with relish, by the Financial Times on October 1. The FT article added this information:

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.

The 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.

“The 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 price.

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.

Amazingly, 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.

He 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 Daily.

Of course, if China were to sell dollars, the yuan would appreciate even more. 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.

It 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.

Their 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.

October3, 2007

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

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