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When the Music Stops Gary North
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.
This was quoted, with relish, by the Financial Times on October 1. The FT article added this information:
Mr. Prince was a confident man in late July. Very confident. He was quoted in an August 2 article in the International Herald Tribune.
Scared? Not Mr. Prince. Then, over the next month, Citigroup lost $1.4 billion.
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 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 and 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. FROM SMART GUYS TO WISE GUYS This was not supposed to happen . . . not yet, anyway. Prince saw in general what was coming, just not when.
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. Their 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.
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.
CONCLUSION 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.
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