Where No Fed Has Gone Before

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Bear CEO Schwartz may soon face a Senate committee Daniel Acker/Bloomberg News

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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.

Coy is BusinessWeek's Economics editor.