Niall Ferguson on Planet Finance and the Age of Leverage

Great new Niall Ferguson article over at Vanity Fair (!) on the rise and fall of what he calls "Planet Finance", where everyone’s ten CDOs tall, and the transactions outnumber the people. It is lucid, lengthy, provocative and historically grounded, as you might expect from Ferguson.

This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.

Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.

New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of “conduits” and “structured investment vehicles” (sivs—surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.

I may post some more comments about it later, but just go read it now here. And here’s another good excerpt:

Though we tend to think of money today as being made of paper, in reality most of it now consists of bank deposits. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets. A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.

Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of “the Great Repression,” average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.