How Banks and The Fed are Hiding the Credit Crisis

From Freddie Mac's recent earnings conference:
Analyst: There is a headline out there that you have level 3 assets of $157 billion. I was just wondering is that true and is that related at all to the markups of the 1.2 billion gain?

Freddie Mac: No, it is not Paul. We made a determination in the first quarter that given how widely the pricing we were getting on the abs portfolio [varied] that it no longer made sense to leave that into level two. So we essentially moved the entire abs portfolio into level three.

Bloomberg: Financial Accounting Standard 157 allows companies to estimate a value on holdings that aren’t traded. Freddie Mac increased its Level 3 assets under FAS 157 to $156.7 billion, or 23 percent of its assets, from $31.9 billion as of December.

So what happened and why does this matter?
First of all, they found that an additional $125B of loans were of questionable value. In just 3 months.
Secondly, they reclassified them to avoid presenting a market value.

Given that home prices have fallen at least 10% (more actually), Freddie Mac would have had to write down an additional $12.5B (10% * $125B)

That would lead to 2 follow-on problems
1. A much bigger loss
2. A need to firm up their capital ratio

Like Enron, they are deliberately hiding the scale of financial distress. Unlike Enron, they are using legal accounting tricks to do it. And they are doing it in public - meaning that the Fed is very aware of this and complicit. The key here isn't the desire to avoid a major loss. The key is that the Fed would have to move against any bank that has proven to be insolvent (meaning capital ratios can not be maintained).

I figure that every major investor in these assets is doing the same thing: shifting bad assets to Level 3 in order to hide the scale of financial distress. This is how the Fed has managed to solve the credit mess - by sweeping it under the rug. Eventually the loss will come out, but by then the assumption is that the lenders will have better liquidity.

Amazing. Because one expects the Fed to maintain the credibility of the financial system. As they say, rules are made to be broken.

Now we have the final piece of the puzzle.
* The Fed saves banks and investment companies from having to fix capital requirements. The original plan was to use the toxic loans as collateral. But the Fed doesn't have enough money to loan. Instead, the companies disguise the toxic loans as Level 3 assets. The accountants are shut up.
* Return to business as usual - lending, investing and speculation. The Fed lowers the cost of borrowing to below inflation. Better still, for the first time, they lend to investment companies.
* Markets take off. Invetsment companies promptly speculate and drive commodities up 25%

I don't think this will unwind anytime soon. Clearly the Fed is not happy that helping investment companies to recover has come at the cost of rising food and oil inflation. But as usual, they can't resist blowing asset bubbles.

I think the Fed will talk a big game but will not actually do anything that will reduce the speculation.

So we have a conflict set up in the market. On the one hand, stock prices are clearly over valued based on fundamentals. Companies with single digit EPS growth are enjoying PEs reflecting 25% growth.
On the other hand, we have the Fed money flow boosting stock prices.

Eventually, fundamentals will win out. The timing is unclear, because the Fed has shown an amazingly strong desire to help the financial houses out of their over-leveraged position.

It certainly makes me re-think my shorts because my premise was that Wall Street would have to face th emusic. Apparently they don't.