M1 Extended
So the M1 reached a high of about 3.1 in about 1987, and has trended downwards since then. In fact, it dropped off a cliff the end of 2008, and actually dropped below 1 in January 2009. In other words, we clearly are in very different territory. In January, for every dollar that went into the reserve system less than a dollar came back out.
Implicated in the current economic collapse is the issue of leverage. The best definition I have found is a "lesson" at My Critical Capital. Essentially, leverage is debt and a mechanism for extending earnings or value. This is the way that business gets expansion capital, and folks get homes. Another form of leverage is "stock option leveraging." In this type, investors purchase the right to buy a stock at a fixed price under the hopes that the stock will go up and they can sell the stock at a profit. In the foundations of the current situation, both forms of leverage are implicated, but greatly magnified by the creation of new forms of investment based on collateralized debt obligations (CDOs). The following is from "The New Face of Leverage in the Financial System" by Dwight Asset Management Company in their 2007 first quarter report.
"... collateralized debt obligations (CDOs) buy debt securities, pool them together, and issue new securities backed by the pool of debt. In the asset-backed market, CDOs have typically purchased mezzanine classes of asset-backed deals, specifically the tranches rated BBB by the rating agencies. Some CDOs even buy the mezzanine tranches of other CDOs (those deals are often referred to as "CDOs squared"). The diversification achieved by purchasing bonds from different deals sold by different issuers, coupled with a senior/subordinated tranching structure, allows these CDOs to create large senior classes of securities rated AAA. But the lower-rated classes are again levered to the performance of the underlying collateral--in this case, securities that are themselves already a form of leverage. And if correlation in an asset class is high, the diversification doesn't help much.
Later in the report ...
One can see where this is going. Leveraged investors buy levered bonds, which are backed by different levered bonds, which are backed by levered assets. This scenario leaves a razor-thin margin for error. But while financial innovation has amplified some of the risks associated with traditional investing, it has also created the means to hedge those risks. Credit default swaps, for example, allow investors to buy protection against defaults on the securities they own. As the mezzanine classes of CDOs and asset-backed securities plummeted during the first quarter, credit default swaps referencing
those types of securities soared.
And so investors "hedge" their bets - in part via "hedge funds" - private, largely unregulated investment firms that cater to the big investor (in excess of $1 million) and aim for a high rate of return. So the hedge funds were intimately involved in the highly leveraged CDO market, but they in turn tried to reduce their level of risk by taking out insurance on their "investments." One of the major players in this specific form of insurance was AIG (American International Group) whose London office sold Credit Default Swaps (CDS) of CDOs - insurance on CDOs. This is a major reason that AIG has been such a money sink - and likely will continue to be.
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Here is an extended discussion of money availability, the M1, and other issues - "Printing money to boost asset prices?. Choong Huat Hock, The Star Online. 2/16/2009.
AIG: The Tally Mounts (And Gets Murkier). Paul Kiel. ProPublica. 3/02/2009.
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