--In today's Daily Reckoning we'll look at why the current placid market conditions are the calm before another credit storm. At issue is whether the Federal Reserve really intends to withdraw its support of the U.S. mortgage market. At stake is what happens to global capital flows, currencies, and tangible assets if the Fed retreat sparks a rise in interest rates.

--But first, what in the shillelagh is the Fed actually thinking?

--The U.S. private banking cartel left the short-term price of money unchanged overnight. In announcing its decision it concluded that, "Economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

--April gold futures were up $17.35.

--To be clear, a shillelagh is an Irish cudgel, used to beat things or threaten drunken bar patrons on St. Patrick's Day. Ben Bernanke is not Irish, as far as we know. But the Fed has used its digital printing press to beat 10-year interest rates into submission. That's kept a lid on U.S. 30-year mortgage rates and prevented a further implosion in the American housing market.

--In the States, the irony is that crappy subprime-backed mortgage collateral has been replaced with U.S. Treasury Notes and Bonds. Ultra safe, right? Not!

--On Monday, that both the United States and the United Kingdom could lose their AAA rating on sovereign debt if they don't get domestic finances on a more solid footing (cut spending and reduce borrowing). U.S. banks are absolutely stuffed to the gills with government debt. A ratings downgrade would wipe out a huge chunk of bank collateral. Some improvement in the last two years, eh?

-->Age reports that, "National Australia Bank revealed yesterday that its $18.4 billion portfolio of troubled credit instruments had caused losses of $1.3 billion over the past two years. It was NAB's first disclosure of the damage done by the holdings." Better late than never.

--NAB says it has an $18.4 billion portfolio of "troubled credit instruments." With total assets of $654 billion, $18.4 billion seems like a drop in the bucket. You wouldn't want to take an $18 billion loss. And by all accounts, NAB says its losses are under control.

--But it does make you wonder, doesn't it? Are Australian banks really as insulated from further loan losses as UK and US banks? If property prices never fall in Australia again (commercial and residential real estate) maybe so. But we have our doubts.

--One useful nugget is that the NAB bank has set up a new entity for its "troubled CDOs." It's a vehicle to quarantine its "Specialized Group Assets." Or, the financial equivalent of locking your crazy syphilitic auntie in the attic and chaining her to the wall. She might not be going anywhere. But at least she won't be infecting the rest of the household.

This has given us a preview of what we suspect the Federal Reserve is going to do. It's our view that the Fed cannot realistically remove support from the mortgage market. Its announced intention to do so is merely cosmetic. Its placating

--Putting aside the implications for bank collateral, we're talking a serious systemic collapse of the U.S. housing market. If you think that unlikely, then you're not paying attention to just how unsuccessful the Federal loan modification programs have been. Housing prices are not recovering in America, and they won't for some time.

--So if we're right and the Fed can't risk tipping the housing market into apocalypse, how will it behave? "Specialised Group Assets" are a clue. This is a distant cousin of Henry Paulson's "Bad Bank" idea at the beginning of the crisis. It was conceived as a government-funded entity that would but all the garbage debt off the banks at some small discount to the theoretical (not market) value of the loan portfolio.

--The banks would get rid of the troubled assets and have a clean balance sheet. The loans would be concentrated into a government agency that could modify the loans to its heart content, delaying foreclosure, lowering the interest rate, and lengthening the duration of the mortgage.

--Mind you there are heaps of problems with this solution. How will the government agency be funded? Will it create a new class of zombie properties that are carried at above-market valuations and prevent a market-clearing price from emerging in the U.S. market? And won't it keep millions of U.S. borrowers in debt for many years, stuck with an asset that doesn't appreciate and a debt that doesn't amortize?

--Who knows?

--But we think the Fed will find a way to fund, in some underhanded fashion, a new entity to centralize the risk of the U.S. mortgage market. Risk has been concentrating in fewer and larger institutions over the last few years. But the mortgage debt is still too toxic to be borne by any institution that wants to appear healthy and well capitalized in the market.

--The Fed also wants to clear the MBS off its balance sheet so it's free to engage in more QE (which will be necessary when U.S. deficits cannot be funded by creditors and the interest cannot be paid by tax receipts alone). So, the bad housing debt must be off-loaded.

--Of course this is all speculation. But it is impossible now for the Fed and the banks to tolerate a further write-down in collateral. It must be marginalized or exempted from being carried on the main balance sheet. A great mortgage default moratorium is coming, and all the assets tied to the mortgages in question are going to be off-loaded on some credit leper island.

--At least that's how we'd do it if were trying to save a doomed system without freaking out the public and sparking a run on the dollar. Thankfully, saving a bankrupt system is not our job. Surviving it, however, is.

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