“The worst loans are made in the best of times.”
- Alan Greenspan

I'm frequently asked the following question: "How on Earth did we get into this mess?"

This question can be answered in both simple terms or with complicated industry clichés and jargon. The simple answer is that massive amounts of debt and liquidity have been created. The more complicated answer involves the Wall Street greed machine turning the debt into securities that are so esoteric that in my opinion it's threatening the entire fabric of our financial system. These securities are so pervasive that it has kept those at my firm. Atlantic Advisors, away from credit risk for the past couple of years now.

The second-most frequent question would be "Is this mess over and what comes next?" My standard answer is that "They have probably sung the National Anthem but we haven’t gotten to the seventh inning stretch."

I will highlight in this part how I think we got here, what comes next. In next week’s part, I'll discuss what the next part of this crisis might look like.

How Did We Get Here?

Unfortunately, the short question doesn’t have a short answer. Money and debt creation can be directly linked to rising asset prices. So it's important to know not only the current money supply, but the acceleration of money creation. Once money has been created, debt is created via the "multiplier effect," and then funneled into asset prices.

While M3, the total money in circulation in our economy, is no longer reported by the Fed, it is easily reproduced as the inputs for M3 still exist. Courtesy of http://www.nowandfutures.com/, below is a chart I highlight often in commentaries, a chart of reconstituted M3. There are a couple of particularly noteworthy features of this chart. The green/black line is the actual number of dollars that began to accelerate in 1994 (note that the year 1994 will come up often in this piece as I believe it was the genesis of the mess we find ourselves in at present). Further, note that the Bernanke Federal Reserve stopped reporting M3 in February 2006 (this is the black part of the line that is now parabolic).

When questioned by Senator Jim Bunning on November 15th, 2005 why the Fed was suspending the release of M3 data, Bernanke responded with the following answer:

"My understanding is that the Federal Reserve decided to discontinue publication of the monetary aggregate M3 because the costs of collecting and processing the underlying data were judged to exceed the benefits. The Federal Reserve will not withhold the M3 data from the public; rather, it will no longer collect and assemble that information. The Federal Reserve will continue to collect data for and publish the monetary aggregates M1 and M2 and their components.

The benefits of continuing to publish M3 appear to be minimal, because M3 has not been actively used in the formulation of U.S. monetary policy and, at least within the Federal Reserve, has not been found to have much value for economic forecasting."

With all of the money the U.S. government spends, I have to ask why it decided that calculating M3, which can be done in a spreadsheet, was too expensive. One of the largest components in M3 is money in institutional money funds, which is now pushing $4 trillion. I may not be the brightest crayon in the box, but $4 trillion of liquidity is not trivial in my opinion.

Not only has the amount of dollars being created accelerated twice (from 1994-2000 and from 2003-present) but the trajectory is now nearly parabolic and pushing a 20% annualized rate of change. I have been writing about this subject since 1998, when I was running Sedacca Capital Management and my hedge fund Sedcap Partners 1, and I would be happy to re-release any of those market commentaries from 1998-2002 for anyone that would like to see them.


Click to enlarge

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