The Decline and Fall of a High Finance Wizard

By now, anyone with half an inkling of awareness knows the Federal Reserve is in the brutal business of expropriation.  Arbitrarily creating or destroying money has the effect of creating or destroying claims to goods and services.

What we’ve witnessed over the last several decades is that increasing the supply of money first increases asset prices, and later increases consumer prices.  Conversely, decreasing the supply of money decreases asset prices, and, eventually, and often in concert with a recession, slows the rate of consumer price inflation.

Now, after the most radical credit creation binge in modern history, the Fed is in the early stages of a credit destruction purge.  On June 16, the Fed hiked the federal funds rate by 75 basis.  This was the Fed’s most aggressive rate increase in nearly 28 years – since November 15, 1994.

How many fund managers remain who were in the business in 1994?  How many are navigating through uncharted waters?  Are they prepared to answer the margin call from hell?

When you purchase a Treasury note you are lending money to the government for a specified period of time (i.e. 30 days to 30 years) at a fixed rate of interest or yield.  The risk of default on Treasuries has generally been considered nonexistent.

The federal government, with assistance from the Federal Reserve, can always print money to pay its debts.  But this isn’t without risks.  Because printing dollars to pay debts devalues the existing stock of dollar.  So while the nominal return is preserved…the inflation adjusted return goes negative.

In short, inflation destroys Treasury values for investors.  To account for expectations of rising inflation, yields rise.  But this presents another problem for long term Treasury investors.

When Treasury yields go up, Treasury prices go down.


Over the last 24 months, the yield on the 10-Year Treasury note has increased from 0.5 percent to over 3.09 percent – or 259 basis points.

Treasury investors have been getting wrecked.  Moreover, as interest rates rise, and borrowing costs become more expensive, several other things happen.

High priced stocks become less attractive.  House prices adjust downward to account for higher mortgage rates.  In addition, higher borrowing costs make it harder for over leveraged zombie corporations, state governments, municipalities, and Washington to roll over their debts.

This is all part of the credit cycle.  And it should come as no surprise.

Credit cycles ebb and flow from periods of lower interest rates to periods of higher interest rates.  From when credit is cheap and readily available to when credit is expensive and harder to come by.

Yet, somehow, when the price of credit rises, many people – including people who should know better – are caught with their pants down.

When interest rates rise, explosive things happen.  There are financial blow ups.  Long Term Capital Management, for example, in 1998.  Or Lehman Brothers in 2008.  Sometimes the stock market crashes…like the Black Monday crash of 1987.

There are many well-known episodes.  In 1994, for instance, the last time the Fed hiked the federal funds rate by 75 basis points, the Mexican peso got scorched.  In the space of one week the peso fell 44-percent against the dollar.  Mexico’s economy crashed too.

Today we look to a lesser known blow up from late-1994.  With pension fund managers scratching to make up for significant cash shortfalls, similar iterations of the story that follows may soon play out in a city or town near you.

For Love of the Job

“If you do what you love, you’ll never work a day in your life,” goes the old saying.  This implies that work is something to be avoided.

Some work is certainly better than others.  Negotiating land deals is generally better than trapping urban skunks.

Still, any job that creates value, no matter how good it is, requires work.  So even if you love your job, you’ll still have to work at it…especially if you want to be any good.

But like a bite of chocolate cake or the application of fertilizer, work ultimately comes at a diminishing return.  By this, there’s a downside to working too hard.

Take Robert Lafee Citron.  He loved his job.  And everyone loved him.  His wife Terry once remarked:

“He can barely stand the weekend at home.  He can’t wait to get back.  I think he’d go crazy without that job.”

Perhaps if Citron had loved his job a little less things would have turned out better for the people who trusted him.  If he hadn’t tried so hard to be the best, he could have avoided an epic disaster of his making.  Instead, for love of the job, Citron was compelled to continuously outdo himself.

Robert Citron, if you’ve never heard of him, accomplished a remarkable achievement.  In 1994, the 69-year old treasurer for Orange County, California, a position he’d held for 25 years, oversaw a $1.64 billion dollar loss of public funds.  At the time, this resulted in the largest municipal bankruptcy in U.S. history.

The trigger for Citron’s destruction of wealth was Alan Greenspan’s increases to the federal funds rate.  In 1994, Greenspan’s Fed relentlessly hiked the federal funds rate.

By 25 basis points in February, March and April, by 50 in May and August, and 75 in November.  These totaled rate hikes of 250 basis points over a 9 month period, bringing the federal funds rate to 5.5 percent.

What happened next…

The Decline and Fall of a High Finance Wizard

Citron trusted his clairvoyance.  He believed he knew what the Fed was going to do before the Fed even knew.  His apparent acumen had garnered him the highest reputation.  He was regarded a wizard of high finance.

He consistently beat nearby investment pools by at least 2 percent, hauling in millions of extra dollars for local governments.  Thus, a steady flow of cash came his way.

Amazed by Citron’s results, schools, cities, and districts tripped over themselves in their rush to invest with him.  Yet few people bothered to ask how he produced these miraculous returns.

Citron’s strategy was centered on a core belief.  That following the 1991-92 recession interest rates would remain low, and the difference between short-term yield and long-term yield offered an opportunity for arbitrage.

Citron used structured notes to exploit this.  Then he leveraged the entire portfolio using what Merrill Lynch called “step-up double inverse floaters” to further amplify the gains.  The name alone implies disaster.

Through a series of reverse repurchase agreements, Citron used his securities as collateral for loans to buy even more securities.  He levered a sizable $7 billion portfolio into a $20 billion position.

The leveraged strategy worked perfectly, amplifying gains, while interest rates followed his predicted path.  But when interest rates rose, the fund quickly sank.

Starting in February 1994, as the Fed commenced its relentless rate hiking regime, Citron’s amplified gains quickly turned to amplified losses.  As the rate hikes continued, the losses became overwhelming.  Orange County had to declare bankruptcy.

And after 25 years of service, Citron was greeted at his front door by County officials with his pre-written letter of resignation.  Refusing to sign it was not an option.  Soon after, he was thrown in the pokey.

The grand jury investigation later found that Citron, “relied upon a mail-order astrologer and psychic for interest rate predictions.”

In March of this year, after holding the federal funds rate near zero since March 2020, Fed Chair Jay Powell began hiking rates in a futile attempt to control inflation.  First by 25 basis points in March, then 50 in May, and most recently 75 in June.

How much further can Powell raise rates before a large municipality near you goes bust?

We shall soon find out.

[Editor’s note: Don’t let the Fed’s failing efforts to contain inflation blow up your investment accounts.  With consumer prices melting up and asset prices melting down it’s time to extreme caution is warranted.  For this reason, I’ve dedicated the past 6-months to researching and identifying simple, practical steps everyday Americans can take to protect their wealth and financial privacy.  The findings of my work are documented in the Financial First Aid Kit.  If you’d like to find out more about this important and unique publication, and how to acquire a copy, stop by here today!]


MN Gordon
for Economic Prism

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