Saturday, December 15, 2007

Things That Go Bump in the Night

From 1990 until the spring of this year, we saw the development of what Paul McCulley calls the shadow banking system. Non-depository institutions and funds created massive amounts of new money based on leverage. The Fed has lost control of the money supply, because the banks it regulates no longer are the primary movers of debt creation. Investment banks, hedge funds, SIVs, and a score of new investment vehicles have been created to finance a vast array of "stuff." Corporate loans are syndicated by banks but are then sold to non-banks (CLOs and hedge funds), who leverage the loans up beyond what a bank could do.

All that credit exploded the largest measure of the money supply (M-3, over which the Fed has no control - none - zip - nada) and lowered the risk premium for all sorts of investments and encouraged yet even more leverage in order to keep up portfolio returns.

But that changed this year and in particular in August. We are now seeing a de-leveraging that is unprecedented in the modern era. This is increasing risk premiums (which I think is good), but it is also deflating the total money supply. We are seeing two bubbles, the housing market and the credit markets, deflate before our eyes.