A consortium of banks is considering injecting $3 billion dollars into Ambac, the mono-line insurer that relies on its AAA rating to insure, amongst others, municipal bonds and CDOs (collateralized debt obligations). What appears as a rescue plan and may appease the markets short-term, may plant the seeds for disaster.

Mono-line insurers used to be in the business of insuring municipal bonds. For a small fee to the insurers, municipalities were able to attach a AAA rating to their bond offerings, significantly lowering their borrowing cost. The market was so attractive that a short-term market was created where long-term debt was packaged into "auction rate securities" (ARS). ARS are a kind of commercial paper attractive to, amongst others, money market funds and treasury departments of large corporations. Municipal bond funds are also large buyers of insured municipal debt.

Then two developments caused the insurers to veer from their path: as public companies, mono-line insurers were looking for new income streams. Not only that, rating agencies told these insurers that they are not very diversified, that they may have to have a second look at the credit ratings if they did not broaden their insurance coverage to, say, securitized mortgage products. Rating agencies were eager to see the market of debt derivatives expand, so that they could facilitate a market by providing credit ratings to structured products.

There was one further market that was developed to close the circle of financial sophistication: credit default swaps were created. Think of a credit default swap as a put option that will pay you if a company or a security fails.

With a perceived foolproof arsenal of financial tools, banks felt encouraged to carry a lot of complex financial products on their balance sheets. By buying insured securities, or by protecting against the default of an issuer, the banks reasoned, they could show stellar balance sheets. Banks are in the business of lending money; to do so, they require reserves. That arsenal of financial tools, however, is at risk of turning into an asinine collection of toxic waste if the securities held are not as secure as they seem to be or if the credit default swaps are not worth the paper they are written on.

One risk that few talked about until recently, is counterparty risk. Your insurance is only as good as your insurance company. Your credit default swap is only as good as the party you contract with to setup the agreement.

And that's where we are: the banks are scared that a significant part of their reserves may be downgraded. In practice, the market trades these securities as if they had been downgraded; but for the purpose of preserving capital ratios, a AAA rating on paper continues to satisfy the banks' top regulator, the Federal Reserve (Fed). Selling these securities is not a preferred option for the banks, as many are - even in good times - illiquid; and in the current environment, a fire sale would cause serious harm to the banks holding the securities.

However, banks are on an increasingly shaky foundation. Add a few ingredients to set the stage for more volatility in financial markets. Maybe most vocal have been the municipalities that have seen the cost of borrowing surge as the ARS market has vanished. Municipalities have to learn the same lesson as holders of mortgage-backed commercial paper: the buyers of short-term securities tend to be risk-averse investors. They like the extra bit of interest they get from exotic instruments, but as soon as they realize that the securities they have been buying are risky, they walk away. Money markets fund have no interest in holding risky securities; many were foolish to buy these securities in the past, but those days are gone and won't return. Municipalities, however, are political beasts. In their view, mono-line insurers have betrayed them by risking their credit rating through reckless veering into riskier lines of business; they believe that insurers have a contractual duty to try to preserve their credit ratings. And they have a point; not only do they have a point, the municipalities exert influence over attorneys general and insurance licensing, amongst others. When CEOs are threatened with jail time - and we are not suggesting that this has been done yet, nor that fraud has been made public to date that would warrant that -, they listen to the requests of municipalities. Hence the calls to have these insurers split up into their traditional, as well as the riskier business. Such calls are difficult to implement as the holders of insurance on mortgage products also have rights. Just as it took years to separate the tobacco liability from integrated food and tobacco conglomerates, it takes more than a few tough words from a regulator to split mono-line insurers. Note that municipalities will get through this, but their cost of borrowing will likely go up, and they will have to revert to long term financing options for their obligations.

The one proposal that would work is Warren Buffett's proposal to re-insure $800 billion worth of municipal debt. However, the terms of his proposal are not deemed attractive by the mono-line insurers, they would de facto give most of their revenue stream to Warren Buffett's recently created municipal bond insurer, while causing their remaining business to collapse. The problem is that one cannot force the mono-line insurers into action until there's a crisis (read: downgrade by rating agencies); however, the ripple effects of a crisis are exactly what various stakeholders try to avoid.

In this environment, many have been praising the proposed "bailout", a capital injection of $3 billion by a consortium of banks. The complexity of the issues at hand is blinding banks, regulators and rating agencies alike. An investment of banks into the insurers concentrates risk further, rather than spreading it. Banks are closer to being their own counterparty to their credit default swaps. Banks may technically be able to provide the appearance of independence by keeping their stake below certain thresholds. But given that the entire industry has very similar issues, this is a rather weak smokescreen. Indeed, we consider it a pathetic waste of bank shareholders' money. Banks may buy some time if they can convince the rating agencies to go along, but all involved better pray that the housing market and the economy do not deteriorate further, as otherwise, another wave of securities may fail and yet another "bailout" may be required. We used to criticize Japanese shareholder crossholdings, building a house of cards that eventually had to collapse. U.S. financial institutions are laying the foundation for the same mistakes.

The irony in all this is that there are solutions to this crisis: prices have to come down and banks have to be recapitalized. Housing prices have to come down, risk premiums have to go up. Banks have to look for additional, substantial capital infusions. At this stage, however, there's little interest in the tough medicine. Adding significant capital would likely cause further downward pressure on share prices of financial institutions, something few desire. And no policymaker has an interest in lower housing prices, as that will cause further ripple effects. Instead, the Federal Reserve is fighting the credit contraction with all of its force. Unfortunately for the Fed, it is a tough battle to win. The more the Fed tries, the more side effects we may see, such as higher commodity prices, higher inflation as well as a substantially weaker dollar.

We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.