A good form summary of a credit bubble is presented below, compliments of Credit Suisse:

It starts with some genuine investment opportunity almost always related to a real improvement in technology or fundamentals. As strong price performance turns into a boom, optimistic investors desire to buy more on margin. They leverage up, usually using the buoyant asset itself as collateral. Lenders are all too willing to benefit by funding these purchases – after all, in the worst case, they will be holding valuable collateral. Borrowing terms such as haircuts, loan-to-value ratios, or margin requirements get easier. New money flows in, and associated financial assets begin to take on money-like attributes.

As buying on leverage accelerates, prices and credit conditions blow past what is warranted by fundamentals. There is a monetary expansion in the broad sense of shadow money, but when the bust comes this is quickly reversed. Lending conditions tighten, collateral prices plummet, and highly leveraged optimists are wiped out. Now cash is king; investors do not want houses, stocks, tulips or asset-backed commercial paper. To accommodate this demand for cash the government/central bank must quickly and forcefully expand the monetary base or else the increase in money demand can lead to a painful general deflation.

Meanwhile, the sudden disappearance of good collateral in the financial system has created a dangerous de-leveraging that could feed on itself. The government may respond by increasing its own debt, since public collateral in the forms of treasury bills and such do still have funding liquidity, and by flooding the market with government paper the leverage collapse can be better managed. In this example effective money (meaning shadow money plus the conventional money stock) falls sharply, but it would have fallen much more without aggressive policy actions.

As shadow money is a pro-cyclical, boom-time phenomenon, serving as a medium of exchange to finance a bubble, it affects asset prices directly, but only indirectly affects goods and services prices. An approach to estimate shadow money is calculating the immediate cash embodied in various debt securities: this can be done using asset haircuts in repo markets as well as current market values at FMVs in four points in time: early '07, 2008 Pre Lehman, 2008 Post Lehman, and currently.

If the market had outstanding securities worth $100 billion and repo haircuts of 5%, then effective money would be $95 billion. If prices fell 50% and repo haircuts rose to 20%, effective money would be ($100* 0.5)*(1-20%) = $40 billion. Some asset haircuts are presented below in the attempt to determine effective money.



The exhibit below estimates the size of effective US money stock as a sum of inside and outside money as well as shadow money, broken by private and public.



A simplified breakdown of public and private effective money stock is presented on the next chart.



Lastly, in order to demonstrate the dramatic outflow in private shadow money in the immediately pre/post Lehman economy, and just how effectively subdued the public shadow money response has been in dealing with the pull back of the private sector, Credit Suisse estimates that since 2007 the shadow money in private debt securities (IG, HY bonds, non-agency RMBS, CMBS and ABS) has fallen by 38% or $3.6 trillion to $5.9 trillion, mostly due to a drop in market values, a scarcity of new issuance and, most importantly, a huge increase in repo haircuts. To compensate for this, public shadow money represented by treasuries, agency bonds and agency RMBS, has risen by $2.8 trillion, driven by an unprecedented ramp up in treasury and MBS issuance, and an increase in relevant asset prices.



It is immediately obvious that the expansion of public shadow money is no match for the massive contraction seen in the private side. In this light, the question of the efficacy of the QE rollout and other public shadow money expansion has a tinge of futility to it, and not just in terms of money supply inflection points. The continued risk aversion by banks means inside money contraction, and not outside money expansion, is the threat. Not just the wilful allowance of rising inflation by policy makers, but, much more relevantly, a recovery in loan creation is needed. As Keynes noted, in assessing money demand, in addition to interest rates and growth, the subject of "liquidity preference" is critical - the desire by the public to hold (often abnormally large) cash balances as buffers in times when bad economic outcomes are feared, such as currently. As liquidity preference is a mass psychology phenomenon, it is impossible to quantify and predict. A huge increase in cash demand at a time of weak growth is a rare, dangerous and deflationary occurrence, and tends to occur exactly at financial crises such as this one. The administration's, and the media's, massaging of mass psychology through the constant and repeated message that all is well, in order to rekindle the liquidity preference by the general public, makes all the sense in the world, as absent its intangible "benefit" the road to recovery is doomed from the onset.

But is even this propaganda machine doomed, in a more subversive way? As households whose HELOCs have been cut or whose home equity has diminished, firms whose commercial property has collapsed in value, and banks whole ability to borrow in collateral markets to raise cash has fallen, all face the same problem: as the ability to raise cash has fallen, actual cash holdings must rise. And, unfortunately for the Obama administration, this is not a temporary hoarding, this is a permanent rebalancing in the trillions of dollars order of magnitude. As money demand skyrockets, the velocity of money plummets.

In the pro-cyclical boom of 2002-2007 many components of everyday lives became a derivative of the shadow money system: repo lending became critical to credit creation; home equity extraction became a key means to smooth consumer spending during period of low or no income; off-balance sheet funding of various assets became a major earnings generator for commercial banks. Yet the process appears not to have affected money demand and supply: regular bank loan growth was limited, keeping money stock from soaring, and money demand was held back by beliefs in easy availability of borrowing against collateral. Most dangerously, economic policy, first through Greenspan then Bernanke, was complicit in allowing the boom by emphasizing price level inflation and not effective money. With regular M2 and MZM money supply and demand effected only indirectly by the credit boom and a massive output gap following the 2001 recession, it was never an issue that inflation would soar. A similar credit boom occurred with no inflation in the 1920s also, another period where a major collateralized credit pyramid was built virtually on top of a reasonably stable money stock. The reason, then, as now, key decision-makers did not notice a massive credit pyramid was being built, is because traditional money indicators, which this post argues are essentially useless in the context of today's much more sophisticated from a money and liquidity perspective economy, were fairly stable. If there is one "crime" for which the most two recent chairmen of the Fed should be held in ridicule in hsitory books, it is precisely this. And yet while Greenspan may be somewhat forgiven due to his less academic nature, Bernanke, who was a depression "specialist", should have seen our current predicament coming from miles. That he failed to do so is why future historians and market pundits will not spare him the criticism of being among the primary culprits for the current, multi-generational crisis. In the meantime, the propaganda issuing from every media source is to be expected (and in some ways welcomed) - it merely demonstrates that the administration finally grasps the severity of the problem, and the need for confidence to rematerialize, even if it is through the current meme of Green Shoots (whose very existence is flawed flawed upon more than a cursory examination, whether it is due to seasonal factors, subsequent economic data adjustments, or outright misrepresentations).

Yet now that any hope of a preventative approach has failed and we are stuck with the consequnces, what happens? In order for there to even be hope of recovery, money stock has to rebound. Not only Bernanke, or Geithner, but Obama himself has now demontrated that he is on the same page with regard to explanding the shadow money stock (while presumably providing better oversight and supervision).

For now, the immediate focus should be on whether confidence can return: in collateral, in lending, in risk taking, in entrepreneurship. In the meantime, any talk of inflation is premature. The deflationary shock has to wear off first, and in many asset classes it has not even accelerated yet.

It is ironic that shadow money and credit are not just the dynamo that drives the free market, but also its Achilles heel. While most of the time they serve a useful purpose, currently their purpose is a destructive one as long as they continue to trendline away from recent asymptotes. If history is any indication, the overshoot to the downside will likely be just as severe as the upside overshoot was protracted. In that case, nothing the Fed does can accelerate inflation. Also, while possible that Bernanke has something up his sleeve, it is improbable.

Thus while the market continues trading on a speculative basis and conjecture rooted in the casino psychology that has gripped equity markets (and recently credit markets as well), the long term picture is much less sanguine as the excesses of the credit cycle from the past 60 years wear off and not only asset prices but also repo haircuts find a new equilibrium.

What is certain is that the near-term economy will be driven in spurts and starts as mass psychology shifts from one extreme to another. The next catalyst in my view will be the interplay of the impact of stimulus spending coupled with the failure of the green shoots materializing into anything worthwhile. And while this will make the life of daytraders interesting, the traditional buy and hold approach to asset accumulation must be delayed indefinitely, until the critical equilibrium discussed above is achieved. Until that happens, anyone who claims the economy is headed in the right direction (either much higher or much lower), is merely spreading their own agenda or has an opinion that is fundamentally not rooted in actual facts.

Thanks to Credit Suisse for primary observations and ideas and hat tip to Gunther.