The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.

As reported by Bloomberg News

What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return.

...

The extension of lending directly to non-banking financial institutions -- while under the authority of nominally `temporary' emergency powers -- will surely be interpreted as an implied promise of similar action in times of future turmoil.

As reported by Bloomberg News

Simply stated, the bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the marketplace. To meet the challenge, the Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long embedded central banking principles and practices.

My basic point is that a process of deleveraging, in which many financial intermediaries are simultaneously trying to shrink the size of their balance sheets, has produced a situation in which the quantity of credit available in the overall economy from a wide range of intermediaries has contracted sharply and suddenly—a credit crunch. Moreover, concerns about credit quality and solvency for intermediaries can devolve into liquidity problems, as in an old-fashioned bank run. Firms in the shadow banking sector are particularly vulnerable to this because, like banks, they typically issue short-term, highly liquid debt. The fear that an institution may be unable to meet its obligations to its creditors may trigger a withdrawal of credit—as in a bank run. Of course, the perceived inability of one institution to meet its obligations is likely to cast doubt on the ability of others to meet theirs, triggering chains of distress and systemic risk.

The Federal Reserve was created precisely to stem such systemic risks by acting as a lender of last resort, although not since the Great Depression has the Fed acted to accomplish it by lending directly through its discount window to an entity other than a depository institution. Had the Fed not intervened, however, Bear Stearns would have been unable to meet the demands of the counterparties in its repurchase agreements, and thus intended to file for bankruptcy. Doing so might well have led to widespread fears in the financial markets,

"There was a sufficiently dire and dreadful outcome for that company" [Bear Stearns] to mitigate any moral hazard issue.

From Q&A, as reported by Market News International.

There are those who have suggested that by intervening to forestall, and ultimately prevent, a bankruptcy filing by Bear Stearns, the Federal Reserve risks magnifying the chance of future financial crises, by insulating market participants from the consequences of excessive risk taking...

The negative consequences to Bear’s owners and employees from recent events have been very real—so real that no owner or executive or director of a financial firm would want to be in Bear Stearns’ position. While we clearly knew that our actions, both in the context of the JPMorgan Chase transaction and in the establishment of the Primary Dealer Credit Facility would affect incentives for financial market participants, adding to the risk of “moral hazard,” we believe that the lesson of the actual outcome for equity holders will serve to check and even diminish incentives for undue risk-taking.

They {Bear Stearns} may have had adequate regulatory capital, but their problem was more liquidity than capital. What happened was that there were certainly market concerns about their positions, and confidence began to erode and they began to lose their funding.

     We were not informed of the imminence of the situation until about 24 hours before the event -- probably on Thursday with the announcement of their information that they were going to be likely in default on Friday morning. And it was at that time that we began our emergency response.

     More normally, we would have had more warning and we have had more time to develop a more effective response.

     Going forward, we continue to monitor financial institutions. We hope to improve the liquidity situation by extending liquidity to investment banks, dealers, as well as to depository institutions.

From the Q&A session.

We did not bail out Bear Stearns. Bear Stearns' shareholders took a very significant loss. An 85-year-old company lost its independence and became acquired by another firm. Many Bear Stearns employees, as you know, are concerned about their jobs. I don't think any company is interested in repeating the experience of Bear Stearns.

     SCHUMER: But don't you feel there is a dichotomy between federal intervention, taxpayer money, to prevent systemic risk -- it's appropriate to do for a large investment bank; isn't it just as appropriate to do it in the housing market? Because that also prevent, as a whole, presents systemic risk issues.

     That's the dichotomy many of us are troubled about. Not saying one is a bailout and one is not a bailout or anything like that.

     BERNANKE: Well, the Federal Reserve was acting in its sphere of influence to address financial issues. As I've said, I think housing is very important and we need to address it. But of course that's the Congress' sphere of influence, not the Fed's.

From the Q&A session

MALONEY: Given recent news reports about hedge funds having made huge bets against the stock price of Bear Stearns during the week leading up to its collapse and now reports that Iceland is investigating whether certain hedge funds may have played a role in beating down its currency, do you believe there is a need for any new regulatory oversight of hedge funds? And, if so, what type of oversight?      

BERNANKE: Congresswoman, the concerns that you raise and similar ones are examples, if they were true, of course, of market manipulation, which is already the province of the Securities and Exchange Commission and which I am sure will look into these contentions. So I certainly don't have any objection or any problem with enforcement of securities laws and of investor protection in the context of hedge funds.

     It's been remarkable, the hedge funds have been less of a problem than we anticipated in some sense, and we've seen more problem in some other sectors.   So far, one of our main concerns had been that hedge funds that failed would create losses for their counterparties, the major financial institutions.  Thus far, we have not seen any significant losses taken by a major financial institution because of a hedge fund loss or failure. So in that respect, their behavior has not, so far, created risks for our major financial institutions.

From the Q&A session

The valuation -- the primary valuation was done by Bear Stearns on March 14th, so currently, using the best available market information and including adjustments for the fact that those markets are quite liquid, which is important.

We have had our investment adviser, BlackRock, go through those assets, and they are confident, or at least reasonably confident, that we will be able to recover the full amount if we dispose of these assets on a measured basis, rather than to sell them all at once.

From the Q&A session

CASEY: Now, in terms of your investment adviser, can you tell us something about how they were chosen, number one, and what they'll be paid?

BERNANKE: Again, this is the details. I will speak only from my indirect knowledge, because this happened in New York.

We were operating, obviously, under extreme time constraints. This negotiation was going on over the weekend with the need to have it completed by the time that the Asian markets opened on Sunday.

The Federal Reserve Bank of New York engaged BlackRock on a fee- to-be-determined-later basis that is to be negotiated later, and brought them in to take a look at the assets.  They're a highly respected firm. I think that, you know, opportunity to do a full requisition for services and, you know, that competition for bids and those sorts of things was simply not practical given the short time period.      

 CASEY: Just generically, how would they be paid? Is it straight fee or is there any other arrangement just generally in a situation like that in terms of what the Fed would do?

BERNANKE: I just -- I don't know the answer for sure, and therefore I'd prefer to leave it to President Geithner, who could answer that question for you.

From the Q&A session