Here is a fuller explanation. I am not sure of the original source, but you might find it informative.
"Former FED chief Paul Volcker hits the nail on the head when he says “There has been leveraging in the economy beyond imagination, and nobody was saying we need to do something.”
When he says “leveraging beyond imagination” he means it. In fact, there is really no way to adequately describe it, since the investment vehicles designed to conceal the extent of the leveraging are so complex. Even trying to describe it simplistically can be a chore, but I’ll try:
The bankers, who make loans to people by issuing them “credit” are allowed to count the debt they hold as assets on their balance sheets. Then they are allowed to use those “assets” (i.e., the money owed to them) to make even more loans.
This would be the equivalent of you lending someone $1,000. So you put that thousand dollars on your balance sheets as an asset, and you give someone else a loan of $800 from the $1,000 you are owed, by issuing them a spendable credit.
Then you put that $800 on your balance sheets as an asset, since it is owed to you, and lend someone else $600 on the $800 you are owned, by issuing them a spendable credit.
Then you put that $600 on your balance sheets as an asset, since it is owed to you, and lend someone else $400 on the $600 you are owed, by issuing them a spendable credit.
Then you put that $400 on your balance sheets as an asset, since it is owed to you, and lend someone $300 on the $400 you are owned, by issuing them a spendable credit.
That’s called leveraging debt. (I know that’s a simplistic example, but it will do for the sake of this commentary.)
Now, you only started out with a single $1,000 loan. That’s all of the money you had. But suddenly you have $3,100 in “assets” on your balance sheets even though in reality there is only the original $1,000 you lent out. The rest is simply credits you’ve issued to others, that are “owed” to you.
That’s what former FED chairman Paul Volcker refers to in the below article as “credit alchemy” – the art of making money out of thin air by granting loans based on previous loans, based on previous loans, based on previous loans, ad infinitum.
In reality there is nothing backing up those loans but the “promises to pay” of each of the previous debtors. Of course, to keep the debt pyramid going, you have to make more and more loans, which by definition means you have to make riskier and riskier loans.
But wait. There’s more. If you were a bank, people probably invested in your stock. After all, you were a genius. You were able to turn $1,000 into $3,100 – at least on your balance sheet. And as investors saw what a great businessman you were and how you were able to operate so “profitably,” they invested more and more money in your bank by purchasing its stock. This gave you even more money to loan out, on the same leveraged basis you used in the first place. So your balance sheet continued to swell. Now, instead of $3,000 it’s $30,000. Or $300,000. Or $300 million. Or $300 billion. You get the idea. It continues to grow as you continue to use the money coming in from the purchase of your stock to make even more new loans and then to leverage that debt by using it to make even more new loans. Thus, the “assets” on your balance sheet continue to grow. Everyone begins to believe it can never end. You have figured out the key to infinite wealth. But those assets are not real. They are bloated figures based upon the fact that you have leveraged $1,000 into tens of thousands of dollars, then hundreds of thousands of dollars, then millions of dollars, then tens of millions of dollars and finally billions of dollars. Every cent on your now bloated balance sheet was predicated upon your amazing ability to leverage that original debt into more and more debt, then convince investors to throw more money at you, all of which you are able to leverage and then show on your balance sheet as “assets.”
Then you come up with a great idea: You’ll take advantage of some new laws that have been passed, and begin packaging up all of those loans you’ve issued into “securities” (now there’s an oxymoron for you) and sell them to investors around the world, promising “safe” returns on their investments. After all, if you’re making 6% on the loans you made, you can now promise investors a nice safe” 3% or even 4% on their investment and still rake in 2% or 3% at no risk to yourself. In short, you’ve sold your risk off to others. And as the schmucks (er…ah…I mean investors) buy more and more of your packaged “securities,” believing them to be a safe, easy way to make 3% or 4% on their money, you rake in even moremoney with which to leverage even more loans, with each leveraged loan adding even more phantom “value” to your balance sheet.
But as you make loan upon loan upon loan, you have to reach further into the bottom of the barrel for people to lend to. In other words, you have to relax your lending standards in order to bring in new herds of people wanting to borrow money from you. Then you repeat the process: You package those loans up as “securities” and sell them off to investors through the large investment funds that average people like you and me buy into with our 401k and IRA monies.
This is what essentially happened. The money-changers said packaging and selling the highly leveraged loans – now numbering in the trillions of dollars -- as “securities” would further “spread the risk” and make the investments even safer. Large mutual funds and other types of investment funds began purchasing these “securities” on behalf of investors, as average men and women poured money into these funds through their 401ks and IRAs. But in reality it merely concealed the risk, skillfully transferring it from the Wall Street bankers to the average “Joe” investor. Most investors never realized the “securities” they had invested in through their 401ks, IRAs, or in their mutual fund investment programs, were in reality a pyramid of largely unrepayable debt.
But then a curious thing happened: Some of the riskier debtors began defaulting on their loans. And when the risky debtors started defaulting on their loans, a series of ominous events began to transpire:
- As the defaults began to grow, investors got nervous and gradually stopped investing in the bank’s stock, as the true value of bank’s balance sheet slowly began to drop with each new defaulted loan. This gradually began to dry up the new supply of money needed by the banks to continue making loans and leveraging them.
- The large funds and their investors stopped purchasing the packaged debt-based “securities” being offered by the banks. After all, as more people defaulted on their loans, the value of these “securities” began to drop. Th e large Wall Street funds that had purchased these “securities” began to lose money for their investors. And as their investors reacted by beginning to pull out of the funds, the funds simply stopped buying up the bad debt disguised as “securities.” This further dried up the new supply of money needed by the banks to continue making loans.
- Even relatively good debtors, now unable to extend or refinance their loans because the banks no longer had such huge pools of money to lend, began defaulting on their loans. So good loans as well as risky loans began to go bad. And since these loans were interconnected to all of the other loans through the process of leverage, the whole system began to “unwind” or “deleverage.”
- The bank’s bloated balance sheet suddenly began to deflate like an Aero Bed with a bad leak. Seemingly overnight, our hypothetical bank loses two-thirds of its supposed “value.” In reality, what happened is that the true value of the bank is suddenly exposed. People begin to see that the “emperor has no clothes.” Everything that had appeared to be “assets” on the bank’s balance sheet was in reality unrepayable debt.
- The average “Joe” begins to see the value of his 401k or IRA plunge, losing as much as half, or two-thirds, or even three-fourths of its value, depending largely upon the extent of its involvement in the debt-based “securities” packaged by the banks and sold to the bi g funds on Wall Street, or in investments leveraged off of those debt-based securities by the funds themselves.
Hence, we have witnessed not only banks going under as their bloated balance sheets crashed back to earth due to the loan defaults, but also the stock market plummeting and taking everyone’s 401ks and IRAs and mutual fund investments down with it.
The problem is this: Once this process starts it is hard to stop. After all, at this point literally trillions of dollars are involved in this unwinding debt pyramid. And because investors from around the world purchased those debt-based “securities” (chiefly the large investment funds that average workers invest their retirement funds through), the entire global financial system is being affected.
And the untold story is that many of these large global investment funds used their investments in those debt-based securities as “assets” with which to leverage even more investments. So you have highly leveraged investments that were based upon other investments made up of highly leveraged debt. Oy, vey!
Finally, you can top off this unholy witches brew of leverage with the use of the futures markets which allowed banks and investment funds to leverage their “assets” even further by betting on the future value of investments. With all of that, and more, you have “leverage beyond imagination” as former Fed chairman Volcker puts it.
That’s why many analysts now say the “unwinding” of these investments is unstoppable, no matter how much money the governments of the world throw at the problem. After all, they are simply adding to the problem by using brand new debt-based “promises to pay” (ultimately backed by the already beleaguered taxpayer) to stop the unwinding of older debt-based “promises to pay.” It’s kind of like throwing buckets of water on a drowning man, hoping it will somehow help keep him afloat.
How will it all end? Badly I’m afraid. While everything is de-leveraging now, causing a deflation in the prices of oil, stocks, commodities, real estate, and the value of what were once trillions of dollars worth of assets, we know from Amos chapter 8 that it is all going to end in inflation. In other words, higher and higher prices for smaller and smaller portions, with the poor going into economic bondage to the system. But out of it all, we will most certainly see a new global economic system emerge. And Biblically, that means we are now very close to the events that kick off the end of this old flesh earth age."
Kinda scary isn't it.