And now for the third installment in my mini-series on debt.  Up today: financial sector debt.  If you thought that the charts on household debt and corporate debt were eye popping, then you better put on some dark shades before you continue reading.  As I pointed out in a previous post on the demise of Lehman, leverage in the financial sector has vastly amplified risk.  Lehman clearly is not alone here.  The following chart shows the growth of debt in the financial sector together with the growth of profits.

The profits line barely registers.  According to the stats collected by the Federal Reserve, financial sector debt had reached $16 trillion by the end of 2007.  By comparison, financial sector profits were a paltry $450 billion.  A few things are worth noting here.  First, as with all of these highly aggregated statistics the numbers are to be considered with some caution, but they are certainly directionally correct.  Second, financial sector proftis do *not* include the gigantic bonuses paid on Wall Street.  For instance, even in 2007 as shareholders in the financial sector were already suffering big losses, Wall Street bonuses alone accounted for $38 billion.  If one were to add big banks one could easily see how financial sector profits could be a good 10% or so higher with more reasonable compensation.  But that makes only a small difference compared to the third note, which is that much of the profit that financial sector firms were recognizing in the 2002-2007 period was based on transactions that have either seized completely or are now taking place much more infrequently or at lower valuations. 

The critical chart to look at therefore is the debt-to-profit ratio for the financials sector.  Once again, I use the dotted line to show the hypothetical ratio with profits pegged at 2001 levels.

In 2007 the debt-to-profit ratio surged to 35 using 2007 profits, but using 2001 profits the ratio is at an off-the-charts level of 70 (ok, so it is actually on the chart because Excel by default automatically extends the y-axis).  This explains clearly that the current crisis of the financial system is *not* one of liquidity, but one of solvency.  The financial sector has way too much debt.  With huge leverage the equity in firms gets wiped out quickly, and with comparatively small earnings power (compared to the debt), it is incredibly hard or impossible to raise new equity.

But if you think that is bad, you haven’t taken into account the $45 trillion elephant known as the Credit Default Swap (CDS) market.  Yes, that is $45 trillion (or more than twice the size of the US stock market).  The basic idea behind a CDS is simple.  Party A pays Party B a fee (premium) to insure against the default of a bond.  If the bond defaults, Party B pays Party A the value of the bond.  But there are several important complications.  First, Party A does not need to own the bond.  This explains why there can be vastly more “notional” (the insured amount) outstanding than there are underlying bonds.  Second, Party B can assign the contract to Party C (which can assign it to Party D, and so on), so that Party A does not really know who it has a claim against should the default occur and what the credit worthiness of that final party is.  Third, the party which winds up with the obligation to pay is not required (since the CDS market is unregulated) to in any way hedge this obligation, e.g., by selling the bond short.

So what do we have here?  An additional $45 trillion of contingent liabilities.  Debt that is not included in the above statistics but might turn into real debt depending on events.  Now the counterparty patterns in the CDS market are complex and it is clear that some of the amounts would simply net out when the obligations arise.  A friend of mine who knows this market thinks that 70% or so might net out.  Even if you assume 75%, you are left with an additional $10 trillion in contingent liabilities on top of the $16 trillion identified in the Fed statistics.  Nobody knows who is holding the bag on that $10 trillion, but AIG is certainly a candidate – which may help explain why it is rapidly plowing through much of the government’s bailout commitment