Fed and Bear: moral hazard or greater good?

By Ros Krasny - Analysis

CHICAGO (Reuters) - Federal Reserve backing of Monday's higher bid from JPMorgan Chase & Co to buy investment bank Bear Stearns Cos stirred new talk of moral hazard, even as it was cast as part of an ongoing effort to calm financial markets.

Critics argued that the U.S. government is prepared to rescue a failing Wall Street bank while dragging its heels on help for home-owners facing the possibility of foreclosure.

Still, investors pushed U.S. shares to a second straight session of big gains on hopes that the credit crisis, which has pushed the economy to the brink of, or possibly already into, a recession, might have turned a corner.

Recent moves by the Fed, culminating in Monday's revised JPMorgan-Bear Stearns terms, may have prevented other Wall Street firms from heading into a downward spiral, which would only add to the economy's woes.

The Fed has provided "unambiguous evidence" that it is "committed to being creative and aggressive to protect the U.S. financial system," said Robert Barbera, economist at the investment firm ITG in Rye Brook, New York.

JPMorgan agreed to raise its bid for Bear Stearns to $10 a share from the $2 per share terms in the initial agreement announced on March 16.

Still, Bear Stearns shares are down from $80 as recently as the end of February and from over $170 in early 2007, massive losses which to some made the concept of "moral hazard" -- the idea that investors take greater risks believing the government will protect them from losses -- seem spurious.

TORPEDOES AWAY

Rather than a bailout, the Bear Stearns deal "more closely resembles the torpedoing of a sinking ship," said David Wyss, chief economist at Standard & Poor's in New York.

"The bank is dead," Wyss said. The Fed "treated Bear in the same way that it would treat a failing bank," and arranged a "forced marriage."

By making sure the "marriage" goes ahead, the Fed helps nurture tentative signs of order being restored to financial markets, such as a narrowing of credit spreads and a rise in the U.S. dollar, following months of upheaval.

"Panic over the possibility of a financial system meltdown appears to have subsided, at least for now," said Andrew Tilton, economist at Goldman Sachs.

The Fed may have attempted to inoculate itself from charges of fostering moral hazard by making clear that JPMorgan would be the first to face losses if Bear Stearns' assets went sour, and that the Fed stood to gain if they did not.

The central bank said it will assume control of a portfolio of Bear Stearns assets valued at $30 billion, pledged as security to facilitate the deal. Any profit from those assets will accrue to the Fed, while JPMorgan would bear the first $1 billion of any losses.

The Fed will finance the remaining $29 billion on a non-recourse basis to JPMorgan Chase at the discount rate, currently 2.5 percent.