What a Deal: Trash for Treasuries

And in a speech on April 10, Ben S. Bernanke, the Fed chairman, said: “Investors must take responsibility for developing independent views of the risks of these instruments and not rely solely on credit ratings.”

Yet the Fed is doing precisely that when it accepts triple-A rated mortgage securities. “This is classic ‘do as I say, not as I do,’ ” Mr. Rosner said.

More worrisome, he added, is the fact that the Fed doesn’t examine the basis for bestowing a triple-A rating on these securities. Are they triple-A based on the soundness of the issuer? Or because of an insurance policy guaranteed by M.B.I.A. or the Ambac Financial Group, the troubled financial guarantors?

Both M.B.I.A. and Ambac currently carry triple-A pedigrees from Moody’s and Standard & Poor’s. Fitch, the other major rating agency, cut them both to double-A earlier this year. But as long as the guarantors carry triple-A’s, the securities they guarantee carry them as well.

But what if the guarantors themselves are downgraded? That brings us back to the Fed’s lending entity. If securities posted by brokerage firms at the Fed lose their triple-A rating, they will no longer be accepted as collateral. The brokerage firm would either have to come up with other acceptable collateral or repay that part of the loan immediately.

And if the firm could do neither? The Fed could go after the firm’s other assets. Or taxpayers could get stuck with the bill.

Such a possibility may be farfetched — let us hope it is. But stranger things have happened recently — Bear Stearns disappeared overnight, remember? And a downgrade of the financial guarantors would result in major market upheaval as enormous amounts of securities formerly considered triple-A would have to be downgraded, too.

How much of the collateral posted at the Fed by brokerage firms is triple-A solely because of financial guarantors’ insurance, which is known as a wrap? The Fed won’t say.

But Mr. Rosner said it only stands to reason that much of the mortgage and asset-backed collateral posted at the Fed falls into that category. “Investment banks who are posting the collateral know if the securities are natural triple-A or only triple-A because of the wrap,” he said. “Obviously the incentive would be for them to post triple-A collateral of lower quality to the Fed.”

LAST week, Moody’s said that worsening losses on second lien residential mortgage securities might have an impact on its triple-A ratings on M.B.I.A. and Ambac, known as the monoline insurers. The insurers have significant exposure to these mortgage securities, Moody’s said. Also, incurred losses within both firms’ portfolios are meaningfully higher now, elevating the rating agency’s concerns about capital levels relative to the guarantors’ triple-A ratings.

Both companies disputed Moody’s view that they may need to raise capital to keep their triple-A ratings.

Clearly, it is in the Fed’s interest to make sure that M.B.I.A. and Ambac are well capitalized and deserving of triple-A ratings. In a speech last Thursday, Mr. Bernanke urged banks to keep raising capital to shore up their loss-ravaged balance sheets. He should add the financial guarantors to his list.

Henry M. Paulson Jr., the Treasury secretary, said last week that the credit crisis was abating. If he truly believes this, then the Fed should tighten its lending entities’ collateral requirements and stop being what Joan McCullough, a macro strategist at East Shore Partners in Hauppauge, N.Y., called “a monetary bordello.”

To be sure, crisis times call for creative measures. But as long as Wall Street is allowed to swap trash for Treasuries on the taxpayers’ dime, don’t try to tell me this horror show is over.