Where no Fed has gone before

To understand what's going on, go back to the weekend of March 15-16, when the Fed encouraged JPMorgan to buy Bear Stearns at a fire-sale price to keep Bear from going under and dragging other banks down with it. Even at $2 a share, JPMorgan wasn't willing to do the deal because lots of Bear's assets, despite having an investment-grade rating, were worth almost zero in the then-skittish marketplace.

So the Fed got crea­tive. It set up an arcane arrangement that will give JPMorgan the full appraised value for some of Bear's assets if JPMorgan succeeds in acquiring Bear.

Here's how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear's new owner. JPMorgan itself will lend $1 billion to the Delaware company.

The company, managed by BlackRock ­Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there's money left over even after ­JPMorgan gets repaid, the Fed gets it all.

From an economic perspective, this complex arrangement is functionally identical to a purchase of the Bear portfolio by the Fed—one that's financed in small part by the subordinated $1 billion loan from JPMorgan. But the Federal Reserve Act doesn't seem to provide for the Fed to make such equity investments. That doesn't trouble the Fed because it argues that the $29 billion is indeed a loan—or, to use the antiquated language of the Fed's founding legislation, a "discount" of a "note."

Pushing the limits
A word of explanation: The Federal Reserve Act allows the Fed to advance money to people and companies that can't get credit elsewhere. In the 1930s a big farmer, say, who gave the Fed a note promising to pay $1 million when the wheat crop came in might have gotten $900,000 immediately. (That's a discount from the note's face value to compensate the Fed for its trouble.) The Fed is now arguing that the Delaware company is like the Depression-era farmer, getting money up front ($29 billion) for a promise to pay something in the future.

Of course, the Delaware company is promising to pay not only principal and interest but any money left over as well. It's that residual interest that gives the deal its equity-like nature. But the Fed argues it's just another type of promise to pay that's fully covered under its charter.

If this case proves anything, it's that the Fed is ready to press the limits of its charter to keep the financial system afloat. Effectively acquiring the Bear assets at a bargain price and then liquidating them is similar to what Resolution Trust Corp. did when it shut down savings and loans and auctioned off their loan portfolios in the 1990s. The difference is that Congress set up the RTC but had nothing to do with the Fed's moves. Are the Fed's emergency actions justified? Probably. Are they going to come in for extremely close scrutiny? Bet on it.

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