STUCK ON STUCK?

If you never heard of Robert Citron, you probably won't fully understand James Macintosh's "The Short View" column in yesterday's Financial Times.

Though few parallelisms are exactly the same--that's what ensnares many--it's the concept you have to grasp.

Mackintosh wrote: The good thing about central bankers promising low rates for a long time is it should encourage businesses to take risk and borrow money, without the danger of rate rises pushing up their costs. The bad thing about central bankers promising low rates for a long time is that it encourages investors to take risk and to borrow too.

Robert Citron was a long time Treasurer-Tax Collector of Orange County, California.  As Treasurer he controlled several county funds and he consistently earned higher returns than many other government agencies, so much so he at one point had to turn down money that flocked to him from other agencies. 

These were school boards, water districts and the like, all located in the county, all wanting higher yields or return on their funds, all wanting their drink from the OC Treasury wizard's investment trough.

In many years Citron's returns were nearly twice what those boys and girls in Sacramento were earning for the state of California. That kind of performance attracts attention. And Citron didn't mind the cynosure a bit.

The only Democrat at the time in a highly Republican area, voters overwhelmingly re-elected him seven times. Citron borrowed short and invested long, at one point borrowing money to use as collateral to borrow more money to invest.

The interest rate needle on the velocity meter back then appeared stuck on stuck. Some call it the carry trade, not too much different from what all those yield-starved investors today who've been piling into sovereign debt bonds of EU peripherals, emerging markets, not to mention longer-dated US Treasuries.

But an unexpected interest rate shift in 1994 caught Citron and his highly levered funds on the wrong side in what developed at the time into the largest municipal bankruptcy in US history and Citron's eventual fall from grace.

There are all kinds of leverage out there and nobody really knows how much and what kinds. If that doesn't frighten you, why would you think one of those vampire movies would? Save your money.

Mackintosh quotes a recent Bank of England statement about investors to increase yields selling options, "betting against market falls," another way of saying wagering interest rates won't surprise and volatility will remain flat.

Here's how the Bank of England stated it, overlook if you can the stilted central banker language.

"To the extent that that might reflect imprudent risk taking, it could be an amplifying channel in the event of a sharp rise in market volatility."

In other words, to quote Mackintosh again: "If something goes wrong it could go very wrong."

In Citron's case liquidity dried up unexpectedly, the banks stopped rolling over the debt so he could take advantage of the higher interest rates and Robert Citron became a chapter in municipal financial history far beyond his fondest imagination.