Where no Fed has gone before

By Peter Coy

updated 1:00 p.m. ET March 27, 2008

The Federal Reserve has stretched its mandate up, down, and sideways to prevent a financial market deluge. Now it appears to be stretching the English language a bit as well.

What the Fed is calling a $29 billion "loan" to help finance JPMorgan Chase's purchase of Bear Stearns looks much more like a $29 billion investment in securities owned by Bear. Although the Fed insists that it isn't technically buying any assets, in practical terms it's doing exactly that. All this adds up to a big and unacknowledged step up in the central bank's financial intervention with Wall Street investment banks.

The Fed, of course, is the only part of government with the speed, power and flexibility to arrest a bout of market panic. By rapidly intervening in mid-March to keep Bear from filing for bankruptcy, it may well have prevented a series of cascading failures that could have severely damaged the financial system and the economy.

Many economists and analysts are happy that the Fed stepped into the breach. Nevertheless, now that things have quieted down a bit, the Fed is likely to face some tough questions about the precise nature of its actions as well as the legal justification for them.

The second-guessing has already begun. On Wednesday, Senate Banking, Housing and Urban Affairs Chairman Christopher Dodd, D-Conn., announced an April 3 hearing to explore the "unprecedented arrangement" between the Fed, JPMorgan and Bear. Top officials from the Fed and other regulators, as well as Bear Stearns CEO Alan Schwartz and JPMorgan CEO Jamie Dimon, will likely be grilled about the details.

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'That looks like equity'
Meanwhile, Treasury Secretary Henry Paulson gave the Fed a gentle prod Wednesday in a speech to the U.S. Chamber of Commerce. While saying he fully supported the Fed's recent actions, Paulson stressed that "the process for obtaining funds by nonbanks must continue to be as transparent as possible." He also urged the Fed to continue to work with other agencies to get the information necessary for "making informed lending decisions."

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That's a bit surprising because whatever the deal is, it's far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn't the borrower. So the Fed can't demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What's also odd is that if there's money left after loans are paid off, the Fed gets to keep the residual value for itself. That's what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed's Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview Wednesday: "The New York Fed is the residual claimant. That doesn't look to me like a loan. That looks like equity."

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