“So Mr. Big
You’d better watch out
When only you hang around me
Oh for you now
I will dig
A great big hole in the ground”
Free, “Mr. Big”, 1970

The developed world has dug itself a big debt hole. And it keeps digging. But debt is just one part of the giant global financial markets. Money is shuffled about all over the world in vast amounts that bear little relation to size of the real economy or underlying assets. Just how big are the financial markets? Should we be concerned that they are out of control? What can we do to protect ourselves?

debthole

When I escaped the banking world in early 2008 it was considered normal for the world’s largest banks to be leveraged up by a factor of 50 or even 60 times. That meant their assets were 50 or more times the size of their equity capital, which is assets less liabilities.

Put another way, these banks had to lose just 2% of their asset value and they were bankrupt. Kaput.

Unsurprisingly that was what happened to a great many of them when the crisis struck in late 2008, initially caused by defaulted mortgages sold to poor Americans who couldn’t afford them. But the knock on effects, caused by leverage in banks and investment funds, were widespread.

They’ve moved the asset loss tolerance from 2% loss to around 3%. This is still too risky.

Things are not quite so bad today, although there are still plenty of vast banks with more than 30 times leverage. They’ve moved the asset loss tolerance from 2% loss to around 3%. This is still too risky. Evidence suggests that many speculators are back to their debt fuelled tricks as well.

This bank leverage is just one manifestation of the massive expansion of financial markets in general. For example, according to McKinsey, a management consulting firm, total global debt was 213% of global GDP in 1990, but had risen to 263% by 2010. Government debt alone increased from 44% to 69% of GDP over the same period.

Of course that’s at the global level. Many individual countries have much higher public and private debt burdens in relation to the size of their economies.

But what about other financial markets? After all, debt – made up of loans and bonds – is just one form of financial contract.

Now it’s time for a warning. There are quite a few numbers in this article, and also some complex concepts that could be new to you. But no one ever said investing was easy. All I can do is try to explain it in the simplest way possible.

I’ve put together the following chart to give you some idea of how big those financial markets are. The figures are not perfect, as the data ranges from the end of 2010 to the present day, depending on the source I could find (see sources at end of the article).

However I think it gives a pretty good idea of the magnitude of the issues. Figures are in trillions of US dollars (trillions are thousands of billions, or millions of millions: 1 trillion is one with twelve zeroes to the right).

Global financial markets relative to the economy

That little green block is the size of total world GDP in 2012. All $72 trillion of it.

World stock markets at the end of September had a market capitalisation of $61 trillion, or 85% of annual GDP.

World stock markets at the end of September had a market capitalisation of $61 trillion, or 85% of annual GDP. This represents the current traded prices of all listed shares (stocks), whichever market they trade on, added up.

Total loans made by banks come in at $64 trillion, or 89% of GDP. These include loans made to companies, mortgages and all types of consumer finance like credit cards and car loans. Of this, $49 trillion are “unsecuritised loans”, meaning the banks own them and take the risk. They haven’t been packaged up into tradable bond securities – “securitised” – and sold to investors.

That means securitised loans – loans turned into bonds – are $15 trillion. An example would be a collection of mortgages, packaged together, subdivided into bond securities, and sold to investors. That would be a “mortgage-backed security”.

These securitised loans form part of the total bond markets which amount to $108 trillion, or 150% of GDP. Bond markets are dominated by the paper (tradable debts) issued by governments and financial institutions, mainly banks and insurance companies. But they also include corporate debts and the securitised loans I mentioned before.

 Although a huge amount of time is spent talking about the latest hot stocks, the first thing to note is that bond markets are almost 80% bigger than stock markets. Total debt (bonds plus unsecuritised loans) comes in at $157 trillion, which is 218% of GDP. Now we’re starting to get into the really big numbers.

…emerging and frontier market countries have extremely low debts due to their relatively undeveloped financial markets. Debt is concentrated in developed countries in other words.

Remember, these are global figures. A great many emerging and frontier market countries have extremely low debts due to their relatively undeveloped financial markets. Debt is concentrated in developed countries in other words.

Total household wealth has been estimated at $223 trillion at the end of 2012. That’s all private assets net of private debts. Almost half of household wealth is tied up in physical assets, mainly properties (real estate). That leaves financial household wealth of $116 trillion, which includes cash savings plus investments in (mainly) stocks and bonds, held either directly or in vehicles such as pension funds.

Ultimately, all assets in the world have an owner, and all owners are part of a household. Even the assets of a country’s government are ultimately “owned” by its citizens, even if they have little control over those assets. (The same can be said for the country’s debts.)

So let’s take stock for a second.

Household financial wealth is $116 trillion. But stocks ($61 trillion) and bonds ($108 trillion) combined add up to a higher $169 trillion, even though household financial wealth also includes cash savings.

Total tradable financial assets washing around are much larger than the net amounts held by humanity as a whole.

In other words there is considerable leverage in the system. Total tradable financial assets washing around are much larger than the net amounts held by humanity as a whole.

Mr. Big, you’d better watch out

But we haven’t even got on to “Mr. Big” yet. The financial “derivatives” market. As the name suggests, the prices of derivatives are derived from some other underlying asset. The underlying asset can be something physical, such as commodities or real estate, or it can be another financial asset, such as a stock, bond or currency. You can also have derivatives of derivatives.

Confused yet? Well, I don’t blame you if you are. But let me explain further.

The most common types of derivatives are forwards, futures, options and swaps. I don’t want to get into too much detail here. But put simply a forward or future is a contract to buy something at a date in the future at an agreed price. Forwards are private contracts between two counterparties. Futures are traded on exchanges, similar to stock exchanges.

An option is usually defined as “the right, but not the obligation, to buy or sell an asset in the future at a fixed price”. So, for example, I could own options that give me the right to buy 1,000 shares of a company at $10 before the end of 2013.

An option is different to a future or forward because an option owner is not forced to actually make the purchase (or sale). A right to buy is known as a “call option” and a right to sell is known as a “put option”.

Then there are swaps. This is where two counterparties exchange (“swap”) a set of cash flows for a period of time, linked to some underlying reference assets or prices. The most common type of swap would be an interest rate swap, usually traded between big investment banks or sold to their corporate customers.

Let’s say I am paying interest that varies according to market conditions (variable interest) but want to pay a fixed rate for 10 years. You are paying fixed rate interest but want to pay variable interest for 10 years. We enter into a contract and swap our interest liabilities for 10 years, so I’m now paying fixed and you are paying variable interest.

The basic point to understand is this: derivatives are paper markets that make all sorts of promises and commitments via contracts of one sort or another.

Don’t worry if that’s all too complex. The basic point to understand is this: derivatives are paper markets that make all sorts of promises and commitments via contracts of one sort or another.

And those paper derivatives markets are huge. The total notional size of the combined forwards, futures and options markets is $208 trillion, or 289% of GDP. “Notional size” relates to the amount of underlying assets – stocks, bonds, commodities, currencies – that have one of these paper promises attached to them.

Just this portion of the derivatives market makes promises over assets that are 3.4 times as big as world stock markets and nearly twice as big as the bond markets.

Total derivatives include swaps, forwards, futures, options and one or two other things as well. These amounted to a massive $714 trillion notional value at the end of 2012. That’s nearly 10 times the size of annual GDP, and nearly 12 times the size of the stock markets. It’s also over six times the size of financial household wealth and over three times total household wealth.

Even excluding the massive interest rate swap market, where many argue that the risks are much lower than the notional amount (too technical to cover here today), the derivatives market still has a notional value of $344 trillion, or 478% of GDP.

The bottom line is this: financial markets are huge, debts are massive, derivatives markets are gigantic, and it’s all an enormous, leveraged house of cards that will collapse one day. Probably into a giant hole in the ground.

At that time governments could still bail out their banks. But government debts are much higher today than they were.

If you thought that 2008 and the aftermath was a serious global financial crisis then you ain’t seen nothing yet. At that time governments could still bail out their banks. But government debts are much higher today than they were. One day they won’t be able to borrow to do the bail outs.

Financial markets truly are a “Mr. Big” that you have to watch out for, dear OfWealther. Global leverage is at insanely high levels, especially in developed countries. The world has dug itself a big hole in the ground, even if it hasn’t fallen into it yet. But it could be teetering on the edge. A gust of wind may be all that is required.

For this reason, OfWealthers, I continue to recommend you always own some physical gold. Put it in your own hole in the ground. Keep it there. Forget about it (but not where it is!). One day you may need it.

Stay tuned OfWealthers,

Marco Polo

 

Chart data sources and dates:
Derivatives: Bank for International Settlements, December 2012
Household wealth: Credit Suisse Global Wealth Report 2012
Debt: McKinsey, 2010 (it’s probably even higher now!)
GDP: CIA World Factbook, 2012
Stock markets: World Federation of Exchanges, September 2013