The Great Credit Ratings Cover-Up

Today's comment is by Mike Burnick, Senior Editor, Global Markets Analyst and editor of Market Shock Trader.

Dear A-Letter Reader,

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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Yahoo Quits London for Swiss Tax Haven

As regular readers know, we libertarian free spirits at The Sovereign Society love tax competition among nations.

Taxes are a just another cost of doing business, personally or commercially. Therefore, we believe you should have the inherent right to choose to your business activities in a country that imposes no, or lower taxes. It's insane to do business in socialist Germany, where taxes confiscate 50% of your income, when you could relocate to Liechtenstein or some other tax haven where taxes are minimal.

But tax hungry politicians in greedy welfare states around the world just don't get the message: It's high taxes, stupid, that drive out good businesses and destroy jobs. In this age of globalization and instant electronic financial activity, modern communications and transport links administrative bases can be located almost anywhere.

Thus, last week the news broke from London that Gordon Brown's Labour Party has driven Internet search giant Yahoo to move its European headquarters from London to Zurich. The reason? Yahoo was chased away by ever higher British taxes. The news came a few days after Labour announced a new annual tax levy of £30,000 (US$62,000) on non-domiciled foreigners who have lived in Britain for at least seven years.

Yahoo becomes the latest of many multinational businesses being lured away from the U.K. by rival countries with lower corporate taxes. Google, despite employing several hundred staff in London, opted to base its European headquarters in Zurich. Videogame maker Electronic Arts moved its engineering staff from London to Zurich. EA's rival SCI last month announced it was moving dozens of jobs from Wimbledon to Canada.

Ireland, Switzerland, the Netherlands, Bermuda and Singapore have been the winners with the U.K.'s former EU-leading position as an attractive tax regime at risk, especially since other EU nations introduced lower tax regimes.

Even at a new 28% corporate tax rate, Britain is still well above other countries including Switzerland, where the national average rate is nearer 20%. The Swiss have succeeded in luring a host of big companies in recent years.

More are expected to follow in the wake of the U.K.'s new tax on non-doms. (Meanwhile, the United States government stupidly imposes one of the highest corporate taxes in the world, 35% plus - then wonders why American companies move offshore.)

Swiss councils have been directly approaching wealthy London non-doms running hedge funds and other investment businesses to highlight the benefits of moving to the Alpine haven.

Procter & Gamble and Colgate-Palmolive, the giant U.S. companies, both elected to site their European HQs in Switzerland. Kraft Foods recently left the U.K. for Switzerland. Switzerland is low in tax because its regions, known as cantons, compete against each other.

BOB BAUMAN, Legal Counsel

P.S. The same strategy could work for you and your small business. Discover how you can benefit from low taxes in Switzerland in my new book, Swiss Money Secrets, click here.

Why Bother to Trade Currencies?

In yesterday's A-Letter, I gave you a few quick stock investor tips for trading currencies.

But in the wake of the whole Bear Stearns mess over the weekend, you may be considering switching over to my favorite market all the more now. So let's take a look at some more reasons why currencies can pad your portfolio, when stocks just don't provide the profit potential they once did.

For starters, you can earn DAILY interest by buying these currency pairs rather than earning QUARTERLY dividends in the stocks. This is a huge advantage. You'll also enjoy better fills on your orders (even market orders) because the currency market has more volume than all stock markets of the world combined.

You'll also enjoy the benefit of the extra leverage. Generally in stocks, you can leverage 2-to-1 or 4-to-1. In currencies, you can leverage up to 400-to-1. (But 100-to-1 leverage is much more common.)

Of course, you don't have to use such a high leverage. You can use a conservative leverage of just 10-to-1. That way, you're also greatly increasing the DAILY interest that you receive on your position. Plus, if you're right in your assessment of where the market is going, you'll gain far more than you would in the actual stock index that it tracks.

You can buy or sell a currency pair 24 hours a day Sunday evening through Friday evening. So if you hear of some bad news after the stock market is already closed, you can still exit your currency position while the stock traders can only bite their nails and wait for the opening. There are minimally several times a year where this facet could be of great help to you.

SEAN HYMAN, Currency Director

P.S. That really is just a glimpse at how you can escape the turmoil of stocks with currencies. For more on trading currencies, sign up for our FREE currency E-Letter, My Two Cents.

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