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The Musical Chairs Theory of Markets (Chuck Prince Edition)

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Ciitgroup CEO Charles Prince, in an exclusive interview with the Financial Times, said something I expect he will come to regret:

Chuck Prince on Monday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, saying Citigroup was “still dancing”.

The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

Let me be clear: narrowly, I am not disagreeing with Prince. The subprime meltdown in and of itself isn’t an event of sufficient magnitude to cause a full blown credit contraction. But there are events on other fronts that are pointing to lessening liquidity: the Japanese finally showing some concern about the carry trade; India, another liquidity provider, going through several rounds of interest rate rises to staunch domestic inflation that has resulted from buying US dollars (buying dollars increases the domestic money supply unless the government “sterilizes” it by issuing domestic bonds to soak up liquidity); the Chinese and Gulf states showing signs of domestic inflation and reluctance to keep buying more dollars.

And Prince himself expects things to end, and possibly even end badly:

“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,” he said in an interview with the FT in Japan.

His comments come amid growing fears that problems in the US subprime mortgage market, rising interest rates and concerns about loose lending standards could lead to a downturn in the leveraged finance market.

“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.”

Mr Prince said the way big Wall Street banks and hedge funds had picked up troubled subprime mortgage lenders was an example of how “liquidity rushes in” to fill the gap as others spot a buying opportunity.

Citigroup is a leading lender to private equity buy-outs and has been involved in several financings that have run into problems. Bond and loan deals arranged by banks have been pulled after investors demanded higher premiums and more protection.

From everything I have seen, most market participants, and I mean that in the broad sense, hedge funds, private equity firms, money managers, and the lenders and advisors to them, are going to keep going full bore as long as they can, until conditions become untenable.

In one sense, this isn’t crazy. It’s extremely difficult to call a market top. And in this competitive world with hyperactive deal and investment activity, someone who pulls back early looks like a moron. They will lose their place in the league tables and if they manage money, will suffer in performance rankings. It leads to a syndrome one manager called “the fully invested bear”.

As a result, you have a lot of players who are moving forward in what they know to be a deteriorating environment. Take Prince. He has to talk the market up because Citigroup has become the biggest M&A player by virtue of its funding ability. Now you know that Citi doesn’t keep much (if any) of the loans it originates on its books, so it has to talk up the market to make sure it has buyers for the loans it sells down (whether via syndication or securitization).

The irony is that Prince was brought in to clean up Citi after a series of scandals. Yet Citi is originating more LBO loans than any other firm, which means they have helped enable the erosion of traditional protections to lenders. Some of my friends in private equity have noted that the extremely favorable terms for borrowers have lead PE firms to be casual about due diligence, since if a deal goes bad, the bank can’t force a workout. The PE firms can halt interest payments with no consequences and wait for the economy or the company to straighten itself out.

Even if Citigroup has only limited exposure to LBO paper by virtue of keeping little on its books, I guarantee you that when the credit tightens further and the economy weakens, enough of these deals will come a cropper that there will be a hue and cry to find who was responsible. At a minimum, Citi will have a lot of explaining to do.

And in general, too many people like Prince have faith in markets. Peter Lynch, who achieved average annual returns of 29% for the 13 years that he ran the Magellan fund, once remarked that markets are most risky when people have the most confidence in them. Like Prince, they assume they can keep dancing as long as the music is playing. Yet Prince has in essence said he knows that when the music stops, it won’t be one chair that will be removed, but several, perhaps most. He seems supremely confident in his ability to know when to exit, but with everyone planning to stay as late as they can, he is likely to be underestimating how quickly conditions can change.

Prince’s cheerful words look particularly suspect in light of another article in today’s FT, “Junk-rated loans hit new lows.”

Update 7/11: Some amusing comments on Mish’s Global Economic Trend Analysis (Michael Shedlock’s blog). The first from a reader:

This market is like a suspension bridge where one cable at a time is breaking. Still the bridge is standing and people are still driving cars over it hoping the last cable won’t break while they are on the bridge. This is what we call moral hazard, ignoring risk for the sake of return.

The second is Shedlock’s response:

In essence Prince says “Play the greater fool’s game until we tell you to stop. At that time we will be short ready to go long. This is just as we did at the last bottom and we will screw you again with the same methodology for as long as you are suckers continue to believe our BS, most likely forever”. The comment “We’re still dancing” might just as well be… “We’re scrambling like SOBs to unload our garbage on you suckers”. I leave it to you to decide whether or not this is the “last dance”.

Wish I’d been that colorful…..

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