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Each time the Fed swings into action, it inches ever closer to the moral hazard of an outright bailout for Wall Street.Last week, I commented about the Fed’s latest free-lunch: Cooking up a 28-day term auction for a cool US$200 billion. Yesterday morning, everyone heard about the bailout deal for Wall Street broker Bear Stearns, which the Fed hastily arranged over the weekend.

These are just the latest in a growing series of central bank-sponsored interventions. Each time the Fed swings into action, it inches ever closer to the moral hazard of an outright bailout for Wall Street.

In fact, this is the closest the Fed’s ever come to Ben Bernanke actually dropping dollar bills from a hovering helicopter! Give him time - he’s working up to it.

For Once the Fed Actually Timed Things Pretty Well

The Fed has been widely lampooned for being “behind the curve” in coming up with creative solutions to the credit crunch. They’ve been accused of being either too slow, or too timid, in acting to relieve the crisis.

Last week the Fed’s timing was perfect in rolling out its plan to allow big banks and other “primary dealers” in the financial sector to swap their mortgage-backed securities (of highly questionable value) for high-grade U.S. Treasuries. This $200 billion credit swap has a term of 28 days. That’s just enough time to tide troubled financial firms over safely into the middle of April, after the books are closed on first quarter results on March 30!

In fact, the Fed is pulling lots of strings these days just to keep the financial system solvent. Consider the great credit ratings cover-up that’s currently taking place.

Rating Agencies Turn a Blind Eye to Wall Street’s Misfortune

A recent Bloomberg article details how the nation’s largest credit rating agencies have turned a blind eye to deteriorating credit-worthiness in Wall Street issued asset-backed securities.

“Even after downgrading almost 10,000 sub-prime-mortgage bonds, Standard & Poor’s and Moody’s Investors Service haven’t cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.” In fact, an estimated US$120 billion in sub-prime bonds - still rated AAA by the agencies - DO NOT meet the standard for such top ratings.

In fact, some of this AAA-rated debt has fallen as low as 61-cents on the dollar amid record home foreclosures and sky-rocketing default rates among similar bonds. According to one hedge fund manager interviewed by Bloomberg, “Downgrades of AAA and AA bonds are imminent, and they’re going to be significant.”

A look inside one of these bonds tells a frightening tale. A US$80 billion sub-prime asset-backed bond issued by Deutsche Bank in 2005 is still rated AAA by S&P and Moody’s. Yet, 18% of the mortgage loans in the security are in foreclosure.

Additionally, lenders have already seized 15% of the properties underlying the loan values for this security. Another 10% have been delinquent for more than 90-days.

Another Morgan Stanley Capital sub-prime mortgage-backed security has credit support of 64% relative to the number of delinquent mortgages loans in the pool. But the credit should be at least twice the delinquent mortgages to maintain a top rating.

Why This Junk Isn’t Rated As “Junk”

Technically, much of this so-called triple-A rated debt should have been downgraded long ago. So why hasn’t it? The simple answer is: Fear of too much “collateral damage.”

According to Bloomberg, “Financial firms own high-grade collateralized debt obligations, which package securities such as mortgage bonds and slice them into pieces with varying risk. As the underlying mortgage bonds are downgraded, those securities will also lose their ratings and tumble in value.”

There’s a huge potential “contagion” effect that would ripple through the financial system if Moody’s or Standard and Poor’s dared to downgrade these shaky sub-prime credits across the board. For instance, a bank holding US$100 million of AAA-rated sub-prime bonds needs just US$1.6 million in capital backing such a highly rated credit. - that’s a lot of leverage. And such leverage is fine, as long as the bonds remain triple-A rated.

Should the bonds get downgraded to below investment grade however, under global accounting rules, a bank must put up additional capital. In fact, it would take US$16 million in capital to back US$100 million in non-investment grade bonds.

That’s 10 times as much capital required in the event of a credit ratings downgrade. Wall Street just doesn’t have that kind of extra capital lying around. Bear Stearns found this out the hard way over the weekend. That’s why I expect the major ratings agencies, perhaps abetted by the Treasury Department and the Fed, to continue covering-up the true health of US$650 billion in outstanding sub-prime bonds.

Should these ratings get cut now, the consequences might be unimaginably bad for Wall Street. Think the “financial day of reckoning” that I mentioned last week.

A Nightmare in the Making

At the risk of sounding like an alarmist, I just have one question. What happens to confidence in the U.S. financial system (not to mention the dollar) when people wake up and realize these fairy tale markets (held up by fantasy ratings) turn into a nightmare?

The Fed is merely monetizing Wall Street’s mistakes yet again, while leaving future generations of taxpayers with an even bigger tab to settle, and higher future inflation to fight.

But there’s just no time for such ponderings now, we’re in the midst of a full-blown financial crisis after all. Damn the financial torpedoes, full speed ahead with the monetary printing press.

MIKE BURNICK, Senior Editor & Global Markets Analyst

EDITOR’S NOTE: When the markets are crashing, the savviest investors bet against the markets with specific “put” options. In fact, traders bet against Bear Stearns last week (55,000 contracts were bought before the news broke that the company was collapsing) and cleaned up when Bear’s prices plummeted. The same strategy can work for you with Mike’s service, Market Shock Trader. This service is designed specifically to take advantage of the market’s biggest crises, with well-timed put and call options. Click here to find out more.

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