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Last week I tried to explain how systemically there is one giant and global margin call occurring. Today, I would like to take a step backwards to explain some of the mechanics. Though this is very basic, you must fully understand the “how” in order to get to the “why”.

Everyone knows the U.S. went off the gold standard completely in 1971. Since then, (other than the Swiss until 1999), no nation has had any gold backing (or ratio backing) for their money. All currency has been “fiat” and was accepted on faith alone. Until the 1980’s we lived in a world where the “West” for the most part had clean balance sheets. You could say it was a lingering hangover from the Great Depression, debt, or too much of it was feared. From individuals to corporations, from local government to the federal government, debt, or too much of it was not really a problem.

The other side of the coin so to speak, “dollars”, were over issued which is why foreign governments were turning in their dollars and requesting gold in return. During the 1950’s the Federal Reserve issued more dollars than we had gold (at $35) to back them. This is why the world “ran” our gold reserves which were over 20,000 tons at one point until Nixon closed the gold window. We were left with 8,400 tons and the Fed was free to issue as many dollars as they chose.

Our economic world then changed along with “sentiment” or mentality. The lasting “prudence” from the Great Depression was gone, taking on debt was no longer a scary thing. It was no longer scary because the Fed was creating inflation which made asset prices go up and made existing debt “worth” less and easier to pay off. This is all basic economic history but it is imperative to know in order to understand what has happened. What has happened is that debt has essentially become money. The currencies themselves are debt based and you could say bonds which basically carry no interest are now considered money or even currency.

We have gone full circle from the depression days and are now back to 1929 on steroids. Debt is everywhere, and too much of it across the whole spectrum. The problem in a nutshell is this, there is too much debt and interest rates cannot be pushed down any further to make it serviceable. Add to this the very real situation that very little unencumbered collateral exists and you then get the full picture. You see, our system is set up as a Ponzi scheme on many levels. First, in order to pay off debt, more new debt must be taken on. Look at the U.S. Treasury for example, they have not paid ANY “net” debt down since 1960. Each and every year, new debt is issued to pay off old debt plus an additional amount to pay for the current year’s overspending. Going further and further into debt for the U.S. has never “been” (past tense) a problem. The logic goes like this …”it is not a problem and has never been a problem because …it has never been a problem”. But, it IS a problem. Actually, it is THE problem!

The U.S. “admits” to having over $18 trillion worth of debt (the reality is we owe, and have future promises of close to $200 trillion)! Our economy, even with fudged numbers, double counting and including “hookers and blow” …is only $17 trillion in size. You can go back into history to see time and time again, once the debt owed by a nation becomes larger than their total economic output, the country soon goes “banana republic”. This is not speculation, this is historical fact. The U.S., even with understated debt and overstated economic activity now has 105% debt to GDP. Simply put, we are now in banana republic land!

It is also important to understand “debt” from another angle than just government debt. Another part of the Ponzi scheme has come from the private sector, individuals and corporations. When plant and equipment is built out or acquired, often debt is what funds the action. Individually, when people buy a house or a car (or even go to McDonald’s), they borrow money. We reached a level back in 2006 that I termed “debt saturation”. The world collectively could not take on any more debt. Either the debt could not be serviced, or there was no collateral (unencumbered) to borrow against. This of course led to the markets dropping, real estate dropping and the economy faltering. In fact, one Sunday in September of 2008 we were only mere hours away from the markets and banking systems not opening. What actually happened? The Ponzi scheme ran out of “new money”, plain and simple!

In came Hank Paulson with his $700 billion “bazooka” called TARP. This, we were told is what saved the day. The reality is the Federal Reserve secretly lent out $16 trillion (created out of thin air) all over the world to financial institutions. This money was used to make sure “confidence” did not break. Financial institutions were losing trust in each other so the Fed stepped in and basically said “we will guarantee everything and everyone, if you trust ‘us’ then you can trust your counter party”. It worked. Bank A trusted bank B who in turn trusted bank C, all because everyone still trusted the Federal Reserve.

There was still a problem though. Ponzi schemes all need two things, confidence (which the Fed just took care of) and “new money”. Where would this come from? This came from central banks themselves AND sovereign treasuries around the world. The U.S. Treasury for example has gone $7.5 trillion further into debt over just these last six years.

The ECB and Bank of Japan have also exploded their money supplies. The treasuries of many European nations, Japan, Britain and nearly all Western nations have also gone heavily into debt. All of this new money supply and newly borrowed money has worked its way into and through the financial systems. Very little of it has reached the real economy nor Main St.. This is why it “still feels bad”. Not much of this “financial help” has made it into the hands of the public. In fact, “velocity” which is the turnover of money is making historic lows. On the one hand, the Fed is issuing money at breakneck speed and the Treasury is borrowing at historic levels. On the other hand, the turnover of money on Main St. is collapsing.

The problem is this, the Fed and Treasury cannot push the cart any further. The Fed has their balance sheet leveraged at over 80 to 1. This means they own $80 worth of assets (bonds) for every $1 they actually have as equity or net worth. This means a 1.25% drop in the value of their holdings is enough for the Fed to lose ALL of their equity! (Another way of saying this would be to use the word “insolvent”)

As for the U.S. Treasury, they are at the point where continuing to borrow at the current pace will mean tax revenues will not be enough to pay the interest. This is similar to a credit card borrower who cannot make the minimum payment. You see, interest rates were pushed downward not just to help business and individuals to borrow money. If interest rates were now just six or seven percent, the Treasury would be stretched to just pay the interest! Simply put, interest rates were pushed down so the Treasury could continue to borrow more but not pay more. This situation is now coming to a head because even at one or two percent interest rates, we are now paying as much interest as we were 10 or 15 years ago when the total debt was only a quarter of what it is now!

What I did above was point out the fact that the Federal Reserve is the biggest hedge fund in the world with well over $4 trillion in assets and the U.S. Treasury is the biggest bankrupt with over $18 trillion in debt. It is important to understand, foreigners are no longer buying U.S. Treasuries with the exception of the Bank of Japan. The Fed and BOJ are now by far the biggest buyers of Treasury bonds. The situation has become “circular” if you will between the central banks and their treasuries. The central banks are printing the money (monetizing) out of thin air in order to buy bonds from the Treasury in order to pay interest and pay back previous borrowings.

Let me wrap this up by explaining what a Ponzi scheme is and how they work …until they fail. All Ponzi schemes start with “confidence” (and thus the word ‘con-man’). The investor is promised a return on his money. The conman “uses” the investor’s money, in order for the conman to pay the fist investor he must find another investor. In order to pay these two investors, he then must find two more investors. Then four, then eight, then 16 and so on. The scheme grows and grows until there are not enough new investors left to pay off the existing investors. This is when the scheme fails publicly and everyone finds out they lost their money.

This is exactly what our banking and financial systems are, Ponzi schemes. We are told all sorts of lies to keep our confidence. We are told there is no inflation and in fact we “need” more inflation. We are told unemployment is at multi year lows. The problem is, more and more “marks” are figuring out the lies, confidence is waning. On the other hand, the ability to expand the Ponzi is also strained as the world had reached debt saturation in 2008. Sovereign governments stepped up and began to borrow heavily in order to keep the game going. Now even treasuries themselves have reached debt saturation and can borrow no more. Both necessities to a successful Ponzi scheme are now faltering, “confidence and new money”.

If you doubt this, then ask yourself “why”? Why have nearly ALL Western governments passed into law “bail in” provisions to their banking systems? A “bail in” is where you as a depositor lose part or all of your savings if the bank goes broke. In 2008 it was the government that stepped in and “bailed out” the banks, this time it will be YOU (and your money), the depositor who will bail out the banks. The legislation has been put in place over the last year to 18 months. Do you really believe there would be this type of legislation if they did not intend to use it?

Lastly, what can you do about all of this? I’ve shown you the government has crossed the banana republic threshold, the central bank has gone as far as is practically possible and the banking system has been prepared for a collapse …get out of “it”! “It” being the entire system because it is a Ponzi scheme. “It” being dollars issued by an insolvent central bank and lent to a bankrupt Treasury to borrow. “It” being these dollars held by you and held at a bank within a system which already has contingency plans for how to handle their collapse!

I tried to write this piece in as most basic terms as I could. Most who will read this will say to themselves “this is nothing new, even boring”. To this I say yes, you are absolutely correct but you now have a tool. The next time someone tells you, “you are just a tin foil hat nut job”, ask them one question. Ask them “do you believe the government is broke?”. Overwhelmingly you will hear words of agreement. Then, please copy and paste the above or just forward this to them. Facts are facts and there is no arguing with the above logic. Of course, you might hear the words “but, it’s different this time” …it never is!

For tomorrow I will do another very basic exercise using just three charts for those who are “visual”. As I mentioned above, please use this and the next piece as a teaching tool for those you love and care about because financial wreckage is coming as sure as tomorrows sunrise! Regards,

Bill Holter