Mirror, mirror on the wall, what is the greatest bubble of them all?

In my opinion, the largest bubble ever formed has been the unprecedented growth in credit, derivatives and even derivatives on credit. This bubble will end the same - in despair for those that neglectfully bought at the emotional top.

The problem this time is that free markets are no longer allowed to be ‘free.’ We're undergoing daily intervention from the Federal Reserve and others.

The $64 billion question is ‘will it help?’ My answer is that it may help for a while, but in fact we're playing a game of Hot Potato, where low quality, levered instruments are simply moved from an entity that has profit and loss (P&L) to a quasi-Federal entity that doesn’t have P&L.

The rhetorical question is if you had assets you couldn't sell and couldn't mark-to-market, and someone offered you Treasury securities for them, wouldn’t you make the switch? Of course you would. And Wall Street is doing this now.

The alchemists that designed the securities they now can't sell are turning to the Fed, who at their behest is absorbing these unmarketable securities. After all, if the securities were salable, they would be sold. If forced to price these esoteric securities at market, it could mean the end for many broker/dealers.

The Fed is very well aware of this problem and has come up with some rather innovative financing mechanisms to allow Wall Street to rid themselves of the very securities they created in the first place. This seems like an experiment gone wrong. The Fed is certainly pulling out all the stops.

I have two questions: Will the Fed’s experiment fix work, and if not, what are the consequences?

Are we in a Hot Potato Market?

Hot potato is a game that involves players gathering in a circle and quickly tossing a small object such as a beanbag or tennis ball to each other while music plays. The player who has the "hot potato" last when the music stops is out. Play continues until only one player is left. The game is designed to be fast-paced and high-pressure and is often played by children. The game can also be played without music where there is a designed leader who shouts out "hot!" and the player holding the object is eliminated.
Definition courtesy of Wikipedia.

I recall as a child playing this game, which originated in England and was later adapted for American consumers by the Milton Bradley Company. The game is a children’s concept of what adults might say instead ‘who’s left holding the bag?'

We've been looking for the unwind of credit market excess that originated in 1995 when M3 and Money of zero Maturity, or MZM, began to grow exponentially. As lending standards became more and more lax, the subprime lending market started growing. Sub-prime mortgage origination went from 2 percent of all originations in 1994 to a whopping 18 percent of all originations in 2004-2007. See the chart below, courtesy of Ned Davis Research.

Subprime Mortgage Originations as a % of Total Originations


Click to enlarge image

In the chart below, courtesy of www.nowandfutures.com, I present a long-term chart of M3 + total credit growth + U.S. Government debt growth. Note how the trajectory started to take flight in 1995, coincidentally when sub-prime origination took flight, along with the bubble in equities that peaked in the spring of 2000. All that new money had to go somewhere.

M3 + Credit Growth + U.S. Government Debt Growth


Click to enlarge image

The percentage change has leveled out in recent years but what's important to me is that this chart now indicates the total notional amount of M3 + Credit + U.S. Government debt has now reached record proportions, something on the order of 400% of Gross Domestic Product. The trajectory of growth for the money supply has become parabolic, yet the ‘real economy’ has stopped responding.

One would think if money and credit were growing this fast for this long, we would be experiencing extremely fast economic growth. Instead however, we've reached the point I call ‘Zero Hour,’ or the moment at which the real economy stops responding to monetary stimulus.

She packed my bags last night pre-flight
Zero hour nine a.m.
And I'm gonna be high as a kite by then
I miss the earth so much I miss my wife
It's lonely out in space
On such a timeless flight
-Elton John/Bernie Taupin from Honky Chateau