In recent times, it has become increasingly clear that the Federal Reserve operates with a heavy hand in the financial markets. Through the arbitrary creation and destruction of money, the Fed affects the landscape of claims to goods and services in profound ways.
Over the past several decades, we have observed a pattern: an increase in the money supply leads to rising asset prices before eventually causing a spike in consumer prices. Conversely, a decrease in money supply brings down asset prices and often coincides with a recession that curtails inflation in consumer prices.
Following an unprecedented spree of credit creation, the Fed is now embarking on a phase of credit destruction. On June 16, the Fed raised the federal funds rate by 75 basis points, marking its most aggressive hike in nearly 28 years, a move last seen on November 15, 1994.
How many fund managers from 1994 are still active today? How many are now navigating uncharted financial waters? Are they ready to face potentially catastrophic margin calls?
When you acquire a Treasury note, you are effectively lending money to the government for a fixed term (ranging from 30 days to 30 years) at a predetermined interest rate. Historically, the risk of default on Treasuries has been viewed as nearly nonexistent.
However, the federal government, with the Fed’s backing, can always print money to meet its obligations. This tactic is fraught with risk, as creating more dollars diminishes the value of the existing currency. While nominal returns remain intact, the adjusted returns in terms of inflation can turn negative.
In essence, inflation erodes the value of Treasury investments. Rising inflation expectations lead to higher yields, presenting yet another challenge for long-term Treasury investors.
Blowups
In the past two years, the yield on the 10-Year Treasury note has surged from 0.5 percent to over 3.09 percent, marking an increase of 259 basis points.
Treasury investors have suffered significant losses. As interest rates climb and borrowing costs escalate, several related phenomena unfold.
Overvalued stocks lose appeal, home prices decline to adjust for increased mortgage rates, and over-leveraged corporations, municipal governments, and even Washington find it challenging to refinance their debts.
This scenario is all part of the credit cycle, an ebb and flow between periods of lower and higher interest rates, and tight and loose credit availability. Yet, quite shockingly, many individuals—including those who should know better—are caught off guard when credit prices rise.
When interest rates increase, significant upheavals occur. Financial catastrophes can ensue, as seen with Long-Term Capital Management in 1998 or Lehman Brothers in 2008, alongside stock market crashes like the infamous Black Monday of 1987.
Many notable instances exist where rate hikes have precipitated crises. In 1994, during the last time the Fed hiked the federal funds rate by 75 basis points, the Mexican peso plummeted by 44 percent against the dollar within a week, bringing the Mexican economy to its knees.
Today, we turn our attention to a lesser-known disaster from late 1994. With pension fund managers scrambling to address significant cash shortfalls, similar situations may soon emerge in cities and towns across the nation.
For Love of the Job
“If you do what you love, you’ll never work a day in your life,” is an adage that suggests work is generally something people wish to evade.
While some occupations are undoubtedly more enjoyable than others—negotiating land deals, for instance, is preferable to trapping urban skunks—it is crucial to note that every job that adds value entails a degree of effort. No matter how passionate you are, excelling at your job requires hard work.
However, even the most enjoyable tasks can yield diminishing returns if overdone. Such is the case for Robert Lafee Citron.
Citron was not only passionate about his work but was also wholeheartedly immersed in it. His wife, Terry, once noted: “He can barely stand the weekend at home. He can’t wait to get back. I think he’d go crazy without that job.”
Had Citron tempered his passion for work, perhaps the consequences for those who relied on him could have been less severe. His dedication to excellence ultimately led him into a disastrous situation.
For those unfamiliar, Robert Citron was a notable figure—serving as the treasurer for Orange County, California, for 25 years. In 1994, he orchestrated a staggering $1.64 billion loss of public funds, which triggered the largest municipal bankruptcy in U.S. history.
The root cause of Citron’s downfall was the relentless series of federal funds rate hikes executed by Alan Greenspan’s Federal Reserve in 1994. The increases came at a rapid pace—25 basis points in February, March, and April, 50 in May and August, and finally 75 in November—totaling 250 basis points over nine months, driving the rate to 5.5 percent.
What transpired next was catastrophic.
The Decline and Fall of a High Finance Wizard
Citron placed immense faith in his predictions, believing he could anticipate the Fed’s moves before they occurred. His reputation soared as he was lauded as a high finance guru.
He consistently outperformed nearby investment pools by 2 percent or more, securing millions in additional funds for local governments. Many rushed to invest with Citron, but few questioned his methods.
His investment strategy hinged on a fundamental belief that following the recession of 1991-92, interest rates would stay low, allowing for profitable arbitrage between short-term and long-term yields.
To capitalize on this, Citron utilized structured notes and leveraged his entire portfolio, employing instruments such as “step-up double inverse floaters” to magnify returns—a name that should have raised red flags.
With a series of reverse repurchase agreements, he used securities as collateral to acquire even more assets, escalating a $7 billion portfolio into a staggering $20 billion position.
Initially, this leveraging strategy paid off, producing significant gains as interest rates aligned with his projections. But as interest rates began to rise, Citron’s returns quickly shifted from profits to devastating losses.
From February 1994 onward, with the Fed’s aggressive rate hikes, Citron’s leveraged position unraveled, and the losses mounted, forcing Orange County to declare bankruptcy.
After a quarter-century of service, Citron was met at his door by county officials with a pre-prepared resignation letter. His refusal to sign it was not an option, and he soon found himself behind bars.
A grand jury investigation later revealed that Citron had “relied upon a mail-order astrologer and psychic for interest rate predictions.”
In March of this year, after maintaining the federal funds rate near zero since March 2020, Fed Chair Jay Powell initiated rate hikes in an effort to combat inflation, first by 25 basis points in March, then 50 in May, and most recently 75 in June.
How much longer can Powell continue to raise rates before a significant municipality faces its own collapse?
We are about to find out.
[Editor’s note: As the Fed struggles to manage inflation, make sure your investment accounts don’t suffer collateral damage. With consumer prices rising and asset prices falling, exercising extreme caution is advisable. Over the past six months, I have been researching straightforward, practical measures everyday Americans can adopt to protect their wealth and financial privacy. The results of my research are compiled in the Financial First Aid Kit. If you’d like to learn more about this essential publication and how to obtain a copy, click here today!]
Sincerely,
MN Gordon
for Economic Prism
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