Descent into the Abyss

Abstract

On July 9, 2007, Citigroup CEO Chuck Prince made his now infamous pronouncement, which marked the beginning of the denouement of the housing boom. “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.”1 Mr. Prince’s remarks came at a time some analysts and bankers had begun to express fears that liquidity might drain out of the mortgage market if nascent problems with subprime mortgage delinquencies metastasized into a large wave of defaults. He did not share this pessimism. He reasoned that recent financial innovations had created a more stable, liquid market. “The depth of the pools of liquidity is so much larger than it used to be, so that a disruptive event now needs to be much more disruptive than it used to be.” The assessment was not without merit. He pointed to recent buyouts of troubled subprime mortgage lenders by big Wall Street banks and hedge funds as demonstrations that “liquidity rushes in” to fill the gap as solvent players eagerly invested in buying opportunities. Nevertheless, Mr. Prince’s assessment turned out to be tragically wrong. Even as he spoke, the market for subprime mortgages was shifting into terminal decline.