Let's get one thing straight. The Federal Reserve did not "bail out" Bear Stearns
The Federal Reserve's role in this deal is that "in addition to the financing the Federal Reserve ordinarily provides through its Discount Window, the Fed ... has agreed to fund up to $30 billion of Bear Stearns' less liquid assets."
There's a big difference between "funding" those assets and taking them off JPMorgan's hands. Here's how the Federal Reserve describes its activity, in a publication called The Federal Reserve System: Purposes and Functions:
The Federal Reserve frequently arranges repurchase agreements to add Federal Reserve balances temporarily. In these transactions, it acquires a security from a primary dealer under an agreement to return the security on a specified date. Most repurchase agreements have an overnight term.... Longer-term repurchase agreements are used to address more-persistent needs. The Federal Reserve accepts Treasury, federal agency, and mortgage-backed securities guaranteed by federal agencies as collateral for its repurchase agreements.
On Sunday, the Federal Reserve Board approved two actions. One was to reduce the discount rate itself by a quarter-point and increase the maximum maturity of primary credit loans to 90 days from 30 days. The other was to permit the loans to be "collateralized by a broad range of investment-grade debt securities."
The Fed is simply accepting a different type of security as collateral for the loans, and allowing the banks to borrow funds for a longer period. The only way the Fed will get stuck with this collateral is if the bank goes bankrupt. While that possibility is (finally) higher on people's minds than it was recently, it remains a worst-case scenario.
So there wasn't really a bailout. In fact, the Fed's move more than likely prevented a massive bailout. Bear Stearns had hundreds of billions in liabilities, not to mention its derivative contracts. The counterparties to these agreements, in many cases, were financial institutions whose deposits are guaranteed by Federal agencies. Had Bear defaulted on those obligations, we might have been forced into a real bailout. Instead, taxpayers merely have to temporarily shoulder some additional risk, and earn a lower interest rate for doing so.
But that doesn't necessarily mean the Fed did the right thing. The goals of monetary policy, spelled out in the Federal Reserve Act, are "to promote effectively the goals of maxi;mum employment, stable prices, and moderate long-term interest rates." In addition, the Federal Reserve can contribute to financial stability by acting to contain financial disruptions and preventing them from spreading outside the financial sector. It would do so by aggressively and visibly providing liquidity through open market operations or discount window lending.
Does providing added liquidity to JPMorgan as it acquires Bear Stearns accomplish these objectives? Clearly, it contained the financial disruption. It probably also helped to moderate long-term interest rates, at least compared to what would have happened in the event of a Bear Stearns bankruptcy.
So I think the Federal Reserve acted as responsibly as possible, doing both what it could and what it should by providing the expanded discount window program.
Where I think the Fed is going wrong, however, is in the continued lowering of the Federal Funds rate. Lower interest rates encourage more borrowing, and if there's one thing the housing bubble, the subprime crisis, and Bear Stearns should be teaching us, it's that we should be borrowing less.
Lower interest rates may help a few of the shakier companies stay afloat for a while longer, but keeping a lid on borrowing would be the better policy. And if it means that a few more overextended borrowers get bought at bargain-basement prices by those who were more conservative, it would make for another lesson well learned.
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Fool contributor William Trent holds no positions in the companies mentioned. He co-authored Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements and blogs at Stock Market Beat. His disclosure policy is the Fool's disclosure policy.
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