Over the years, I’ve emphasized the prominent role “Wall Street alchemy” played in fueling Credit Bubble excess.  The Street’s astounding capacity to transform risky loans into perceived safe and liquid securities was absolutely fundamental to the Credit Bubble.  The OTC derivatives markets – including collateralized debt obligations, asset-backed securities, Credit default swaps, auction-rate securities, etc. – were critical for the intermediation of risky, high-yielding loans into “money”-like securities.  This brand of risk intermediation and distortion was instrumental to the historic boom and bust – and this week it returned to the regulation spotlight.

As I’ve attempted to explain over the years, risk intermediation invariably becomes a central issue inherent to protracted Credit Bubbles and their resulting Bubble Economies.  The amount of Credit necessary to sustain the Bubbles rises each year.  And each passing year requires an increasing (exponentially-rising) amount of riskier Credit.  Our government’s massive injection of Credit/purchasing power coupled with interest rate and market liquidity intervention sustained the existing economic structure.  As they say, “that’s the good news.”

For the private-sector Credit mechanism to supplant government Credit will require an enormous expansion of risky loans.  These risky Credits must then either be held directly by the financial sector or intermediated and sold into the marketplace.  Admittedly, this may not be much of an issue today – with government Credit expansion and monetary stimulus abounding.  But there is no escaping the harsh reality that acute Credit vulnerability is only held at bay by Trillion dollar deficits and ultra-loose financial conditions.  I am skeptical of notions of shrinking deficits and a graceful Fed exit.

The unfolding Greek debt crisis, China Bubble vulnerability, and more intense scrutiny of Wall Street risk intermediation now work in confluence to increase the probability for a negative surprise in our risk markets.  Sure, the equities bulls have become intoxicated by some incredible stock and sector performance.  But equity market reflation must be approaching the point of unnerving the bond market.  And it can’t help sentiment that, as reported today by CNBC’s Steve Liesman, a rising number of FOMC members support a timely sale of assets and a removal of the Fed’s extraordinary liquidity measures.  More bearish fundamentals for the private-sector Credit mechanism gladly ignored by a stock market Bubble.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.