...Or The poker game is over... time to play dominoes

I continue to believe that the typical hard working - raising a family - trying to make ends meet American is not being properly educated by the mainstream press about the dramatic financial events taking place around the world that are directly impacting our lives. The press reports only a fraction of what's going on with the world's finances, and moreover often fails to tie together all the disparate information regarding the economic and financial crossroads upon us now. That's why I write these articles now and then. To try and put a few things into perspective. If you already know the drill, consider sharing this essay with someone who doesn't.

Everyone knows that something is wrong with the economy. And most everyone knows it's not just the American economy; it's Europe, and other places as well. Europe has center stage right now. The ongoing crisis there accelerated recently when it appeared Greece could not make payments on the loans it received from other countries. What may not be clear from the headlines though is that a significant shift in this ongoing saga has recently taken place, and it's a game changer. It's something you should understand. If we can dig down even one layer below the headlines, much is illuminated. To make this point let's pick on just one recent headline:

November 9, 2011 CNN online story:

Italian bonds flashing warning signs

The story describes how the interest rates for money being lent to Italy have suddenly skyrocketed. Yes. Interest paid on Italian bonds has risen sharply. But why? Quite simply, investors are starting to doubt whether Italy can pay back its loans. OK. But why now? And what does it mean to you personally if you're not lending money to Italy? Plenty, that's what. The aforementioned significant change that took place actually occurred over in Greece just a few weeks ago. Namely, the deal that was cut allowing Greece to default on 50% of its sovereign debt. Sovereign debt is money that Greece as a county owes to others. Greece was actually forgiven half its debt! Imagine. The country gets to default on half it debt, yet this deal is not being called a default. Believe me, it's a default. Still, meeting Greece half way on settling the huge problem of its sovereign debt repayment may at first seem a reasonable action. But allowing Greece to default on even a portion of its debt in fact represents a huge sea-change in the way things have been handled up to now. Previously, anything that was considered too big to fail, albeit a financial institution or an entire country was, quite simply, not allowed to fail. Such entities always get bailed out. At taxpayer expense. Greece has actually been getting mini-bailouts for a while now. The country is indeed too big to fail because of how many lending institutions might in turn fail if they don't get their money back. It's also been feared a sovereign debt default by any nation may trigger a domino effect, lest other indebted nations get the same idea.

Given that since the crisis of 2008 virtually every troubled too-big-to-fail institution has been bailed out thus far (private or public), people started to believe that the bonds from such entities were as good as gold. And since the interest rates on bonds from Greece and Italy pay a far higher interest rate than US bonds, some believed that this was the place to put ones money for both safety as well as a high rate of return. Former New Jersey Governor, former Senator, former head of Investment bank Goldman Sachs, and former bond trader Jon Corzine had such a belief. Mr. Corzine was recently head of a neverheard- of-by-most people brokerage firm called MF Global. Corzine believed so strongly that Greece would not be allowed to default that he thwarted the will of those around him and bet the whole farm on Greek bonds.

As most of us now know, Jon lost the farm. MF Global is now in bankruptcy, and its customers -who did NOT sign up for Greek bonds- are waiting in line for their money back. Remember that.

MF Global not only invested in Greek bonds with its own money, it also borrowed funds to buy even more bonds. In borrowing, the company was applying leverage to purchase

more bonds than it could afford on its own. You may recall that overuse of leverage is what triggered the 2008 financial crisis. When one is using leverage, small drops in the value of the property (in this case sovereign bonds) create proportionally larger losses to the bond holder. When it was announced that Greece was to get a 50% get-out-of-debtfree card the value of Greek bonds rapidly lost value. In no time the value of MF Global's portfolio of Greek bonds were worth less than the amount the firm had borrowed to purchase them. Since the loan used to buy some of the bonds had lost equity, MF Global was asked by is creditors to come up with additional funds to make up the difference (they got a margin call). MF Global apparently met the margin calls at first. Repeatedly. Until finally the firm had exhausted all its capital (and perhaps the capital of its clients) and could no longer service its debt. End of story.

What should be underscored here is that this overuse of leverage was supposed to have been curtailed after the 2008 meltdown. Clearly it hasn't been. And MF Global does not appear to be a loose canon. Leverage is still in widespread use. Leverage is still used by institutions you trust with your money in order to increase their own profits. Remember that.

Interest rates on troubled sovereign debt such as Italy is rising because lenders are fearful such countries will be excused from their debt... or won't get bailed out again. Much of this sovereign debt has been purchased on leverage -making a default unthinkable- and there is now a scramble out of these bonds because no one wants an 'MF Global experience'. A critical point to make here is that insurance policies had been taken out on Greek bonds specifically to avoid an 'MF Global experience'. These insurance policies have a fancy name; Credit Default Swap, better known as a CDS. The idea was that even if Greece did default on its debts the insurance policies would kick in and pay off the bond holders. But, the insurance did not kick in. Instead the rules were changed! The rules were interpreted to say that half a default is not a default. Why were the rules changed? Because for the very same reason that Jon Corzine thought Greek bonds were safe, the people who sold the insurance policies (the CDSs) thought they would never have to pay off. It is highly likely the rules were changed because a lot more institutions than MF Global would have gone down if a payout had been required. It would easily have been 2008 on steroids if they had played according to the rules. So, the CDS bluff has been called and the players did not ante up. The name of the game has therefore changed.

As the going gets rough, people in positions of power are changing lots of rules. Remember that. This is another reason why the interest paid on Italian debt is rising and why trust in the entire system is eroding. There are other reasons of course, like all the political turmoil in Italy and Greece. But be sure to put the horse before the cart here; the climax of political turmoil taking place in Europe, as soon America, is due to the growing uncertainty about financing sovereign debt... not the other way around. If the political crisis had been allowed to play out earlier we may not be here now.

But again, what does all this mean to everyday people who are not invested in sovereign debt? Perhaps as long as you don't bank or place your brokerage account with an institution that invests in foreign sovereign debt you will be OK, right? No. The problem is the domino effect. One failed company can topple another because a web of leveraged debt is spread across the globe. There is a massive interdependency among Central banks and global financial institutions (like your bank). An action clear over in Greece brought down an American company and may destroy the net worth of its customers. This is only the shot across the bow. Heed the warning please.

Also bear in mind that there are trillions of dollars of investment capital searching for a safe place to park. As one after another safe havens evaporate, capital moves on to the next resting place. Like a startled flock of geese, capital is on the move, swarming around, looking for a safe place to roost (yes I know, geese don't roost). This is causing disruption in all markets, and the effect is exacerbated by the widespread use of leverage. Trust is breaking down, right now... right in front of our eyes. As trust wanes it becomes harder and harder for both public and private institutions to borrow money. It's a question of getting paid back. Who am I lending to? Are they overextended in bad debt? Will I get paid back? Short and long term financing is literally the life blood of what makes economies function. No capital equals no functioning. So we are right back where we were in 2008. Failure of a few key institutions could trigger a lock up in the credit markets that affect everyone.

Except there is actually more leverage in use today than in 2008. And far less government resources to deal with the inevitable fallout. Without even bothering to quote you the facts and figures on this, simply look at it this way; what happened to most of the overleveraged institutions who were about to fail in 2008? They got bailed out. At the taxpayers expense. What message did that send? Right. Any enterprise considered too big to fail began to assume it could always count on a bailout, so why reign in the leverage? High risk was perceived to be low risk. It's human nature. New regulations be damned. Except now things have changed. A bailout is no longer a certainty. That in and of itself is creating more uncertainty, and market volatility is sure to rise as a result.

Note that the current phase of this drama is being played out in Europe. Europe has a much larger group of people that must come to consensus on how to deal with the sovereign debt crisis than America does. The levers of power are far more concentrated in America, and plans are in place to deal with the eventuality of American debt becoming unpalatable to bond buyers. It's very clear that, short of a massive injection of political will, albeit from the Tea Party, the Occupy Wall Street movement, or elsewhere, the US government will simply print any money it cannot borrow in order to pay on its current debt as well as create new debt. This is one of the main reason interest rates are near zero for US bonds while borrowing costs are so much higher in Europe. For now, US bonds are considered the safest place to park capital. But, the marketplace now knows that not all sovereign debt is created equal, and it is reacting accordingly.

America will have its turn though. If you do the math the US is in more trouble than Greece or Italy. There is simply more debt existing then can ever be paid off. Be assured there are only two ways this game will end. Either governments will stop overspending and bailing out bankrupt institutions and nations, and we take a write-off on the bad debt (massively disruptive, which is why it has not been done), or governments will print money out of thin air to keep the game going a while longer (even more disruptive as it could destroy all paper currencies due to hyperinflation, but from a politician's point of view pushes the problem off for a while). There is no 'growing' our way out of this one. We are living through the climax of a nearly 70 year old and now failed economic theory known as Keynesian economics. We are being forced to reinvent our monetary system, and the inevitable time for that to occur draws close. This is no longer supposition. The old system is breaking down in front of anyone with their eyes open. Just don't look for bread lines... a record 46 million people are on food stamps. No need to wait in line. What to do? Consider the following:

All debt is suspect now because so many of the world's economies are contracting. Sovereign debt, State debt, local and municipal bonds are no longer safe havens. At one time these vehicles were safe and sound. Not anymore. Recall that in 2008 AAA top rated derivatives turned out to be based on fraudulently granted sub-prime mortgages. As this essay points out, it's about to be 2008 all over again, only more so because the government simply does not have the resources to bailout every failed institution without hyper-inflating the currency (within an hour of penning this I noticed the following headline on CNBC.COM- Alabama County to File Biggest US Muni Bankruptcy in history).

Since pension funds are heavily invested in debt vehicles they are a potential source of trouble that perhaps little can be done about. But you can do a few things:

1. Most big name US banks are extremely over-leveraged. It is not reported well in the mainstream press, but Bank of America, Chase, and Citibank are the three most over-leveraged retail banks in the US to the tune of trillions of dollars. They are prime targets to topple. When they fail this time they may or may not get bailed out again. The FDIC does not have a fraction of the funds required to make good on customers' deposits. Consider moving your accounts to a smaller, regional bank or credit union (you can easily google this info).

2. Keep some ready cash at hand. In the event of some kind of credit crunch (a.k.a. liquidity crisis), bank failure, or other event... in other words if the dominoes start to fall... some or all banks may close their doors for a time. ATM machines may be temporarily non-functional. I know this sounds like a clip from the movie 'It's a Wonderful Life' with Jimmy Stewart, but there have already been small versions of this eventuality play out, although it's been underreported. 3) Convert some of your assets into gold and silver. Precious metals will be the final landing spot for capital when all other paper based safe havens are gone. The reason why is simple; gold and silver are hard to devalue.

3. The stock market is a huge gamble right now. The normal matrix of company profitability and supply/demand for stocks is no longer in force. Keeping money in the stock market in my view incurs enormous risk. Major gold/silver mining stocks may be an exception if purchased for the long term. Also, find out if your broker is overextended in risky debt in an effort to improve its bottom line. Last I heard Charles Schwab is clean, but do your own research.

4. If there is any sort of disruption due to the financial dominoes falling it is a certainty people will panic and clear the shelves at the grocery store. In a liquidity crisis those shelves may not be restocked as quickly as you are used to. Stock up now on food and supplies.

The Occupy Wall street movement, the Bank Transfer day, the upcoming Dump Your Bank day are just a few of many signs that people are waking up and realizing that unless they start taking action the foxes are going to cart off every last egg in the henhouse. Don't be the last to wake up. I personally don't subscribe to the gloom and doom of 2012, however that may be the year the dominoes topple. Put your assets under your own control as much as possible to minimize the impact. Then later we all get to build a new system that will work better than this one.