The news that AIG had asked the Federal Reserve to provide a bridge loan worth tens of billions set teeth gnashing everywhere across the universe of market watchers. The now time worn phrase moral hazard was trotted out. Weren't we supposed to be clawing our way out of this bailout business?

Our first reaction to the news that the insurance titan had gone hat in hand to the House of Bernanke was to ask: can they do that? We had fallen under the impression that the Federal Reserve lent money to banks, and more recently to investment banks. But we didn't think the Fed was in the business of bailing out insurance companies.

It turns out we were wrong. The Fed is authorized by Depression era amendments to the Federal Reserve Act to lend to pretty much anyone, as David Zaring at the Conglomerate points out. So long as the circumstance are "unusual or exigent" the Federal Reserve may open the discount window to any individual, partnership, or corporation.

Lately we've been feeling that our own finances are a bit unusual and exigent but somehow we doubt that the Fed is going to allow us to borrow from the discount window. Maybe AIG will have better luck.

Who Can Access the Fed's Discount Window? [Conglomerate]

We earlier reported that officials at the Federal Reserve and Treasury are scrambling to find a buyer for Lehman Brothers, perhaps going as far as bending or waiving rules that limit the ability of private equity firms to buy sizable stakes in investment banks. Part of the rationale for this may be because the Fed and Treasury want to avoid putting its own balance sheet or taxpayer funds into what would widely be perceived as another bailout.

There seems to be an increasing consensus among commentators that Lehman won't be bailed out by the Federal Reserve or the Treasury. Over at RealTimeEconomics, Sudeep Reddy adds color to this idea by pointing out that to Fed officials it may well appear that they have already bailed out Lehman. The primary deal credit facility gives Lehman Brothers access to the discount window, allowing it to borrow cheaply against collateral arguably priced at inflated values. Indeed, Bill Gross of Pimco has publicly cited the facility as preventing him from withdrawing from trades with Lehman on the other side.

What's more, the Treasury and the Fed may want to reduce the moral hazard issue in the market by allowing an institution to fail, Reddy says. But its not clear that they will have the luxury of adding discipline to the market. Lehman is deeply intertwined in the credit markets, particularly, and its failure could have unwanted ripple effects, rocking the stability of the broader financial markets. A better solution, some at the Fed believe, would be to find a willing buyer and arrange private financing without a Fed backstop. This most likely explains the Fed scramble to find a buyer.

Would the Fed Let Lehman Fail? [Wall Street Journal]

Shares of Freddie Mac and Fannie Mae have continued to drop this afternoon. Their credit-default swaps are up sharply, and there is lots of talk that they might need to raise more capital. Both plunged to their lowest price in 13 years.

There are a number of contributing factors this morning. Lehman Brotherss analysts pointed to an accounting change may force them to raise a combined $75 billion of new capital. Traders are talking about further write-downs. This morning's "Heard on The Street" column added fuel to the fire, focusing attention at the challenges faced by Freddie.

Unconfirmed, unsubstantiated and possibly baseless rumors began circulating late this afternoon that the Federal Reserve may step in to bailout the government sponsored home lending giants. Both firms definitely fit the bill of being too big and too connected to be allowed to fail, and today's losses may be truly frightening to regulators and Fed economists. The biggest problem with this rumor, however, is that it would involve very quick action by the Fed, something many doubt the backward looking economist types at the Fed are capable of.

Freddie Mac, Fannie Mae Plunge on Capital Concerns [Bloomberg]

Late Thursday afternoon, long after the markets had closed and many on Wall Street had long since evacuated for the long weekend, the Federal Reserve revealed its estimates for the value the Bear Stearns assets it accepted as collateral for the $28.9 billion loan JP Morgan Chase used to buy the firm and prevent its bankruptcy. That collateral was worth just $28.8 billion, according to the Fed.

What this means is that the decline in the collateral value has already eaten through a good chunk of the $1.15 billion of exposure JP Morgan agreed to take as part of the deal. The collateral has already declined by 3.7% in a couple of months. Much of the collateral consists of mortgage linked securities, so unless that market turns around sharply, it seems likely that taxpayers will be forced to foot the bill for Bear Stearns collapse.

Indeed, The New York Post reported this morning that a hedge fund investor in JP Morgan is predicting further declines in the collateral values. Taxpayers are on the hook for any decline past the $1.5 billion hit JP Morgan agreed to take. The Fed is being criticized for not revealing more about the assets that make up the collateral. JP Morgan says it is bound by a confidentiality agreement not to comment.

Hedge Fund Report: Bear Buyout Could Cost Taxpayers [New York Post]

Corporate loan agreements are being drafted to include an express provision allowing lenders to transfer their loans to the Federal Reserve, a loan expert tells DealBreaker. The Fed has been accepting a much broader range of collateral in exchange for short-term loans through what is known as Fed "repos." In a repo, dealers bid on borrowing money versus various types of general collateral.

The new provisions seem to anticipate the possibility that banks might use corporate loans in repos, accessing cash from the Fed in exchange for the credits. In the past the assignment provisions of loan agreements that governed transfers typically did not expressly permit transfer to the Fed. Instead, they permitted assignment to others commercial banks, insurance companies, investment or mutual funds or other entity that is an "accredited investor" under securities laws. The new provision illustrates the ever more pervasive role the Fed has in the current credit markets.

Investors bid up Lehman Brothers' bonds yesterday after news broke that the company was replacing two top executives. The price of protection on Lehman bonds also declined. This reaction--which starkly contrasts to the decline in Lehman's share price yesterday--has government officials concerned.

Government officials who spoke to DealBreaker on the condition of anonymity said they are worried that the market is convinced the Federal Reserve won't let a major US securities firm collapse. This is a cause for alarm because it indicates that investors are not taking into account full range of risks faced by investment banks, which could in turn remove an important market check on risky behavior. Although Lehman and its rivals have been pushing down debt levels recently, cheap debt that is unlinked to institutional risk could encourage a new round of re-levering, one official warned.

"What we saw yesterday was moral hazard in action," the official said.

The price of credit default swaps for Lehman is now half of what it was in March, the Wall Street Journal pointed out this morning. That can be looked at as a dramatic demonstration of the value of having the Federal Reserve's implicit guarantee of Lehman's credit worthiness. In recent weeks, officials from the Federal Reserve have publicly remarked on the dangers created by this guarantee. On Wednesday, Treasury department undersecretary Robert Steel went out of his way to stress that the window was not a permanent guarantee for securities firms.

Just one day after Merrill Lynch chief John Thain urged that the Federal Reserve borrowing facility for securities firms be made permanent, a treasury official sounded the warning that this new investment banking borrowing window may be closed when it ends its initial run in September.

Under Secretary Robert Steel, whose bailiwick covers the domestic financial system, seemed to have crafted his remarks as a response to Thain's. Yesterday Thain told attendees at a Wall Street Journal dealmakers conference in midtown Manhattan that he hoped the facility would be continued after its scheduled expiration. Speaking a the same conference today, Steel went out of his way to emphasize that the facility is temporary.

After he referred to the facility as the "temporary borrowing facility for primary broker-dealers," Steel added: "Notice the first word in that phrase is temporary."

When the moderator pointed out that Thain hadn't used the word "temporary" when discussing the facility the day prior, Steel acknowledged that his remarks diverged from Thain's.

"Notice I just used the word twice," he said.

Steel left open the possibility that the window could remain open after expiration, adding that the regulatory framework for institutions permitted to borrow from the window remains unclear. The major commercial banks--including, most recently, Bank of America CEO Ken Lewis speaking to the conference this morning--have urged that investment banks be subject to the same regulations that restrict commercial banking. Yesterday Thain said he thought a less restrictive regulatory framework was more appropriate.

At a gathering of Wall Street dealmakers yesterday Merrill Lynch chief executive John Thain said he hopes the Federal Reserve will continue to permit securities firms to borrow from a new Fed facility launched amidst the implosion of Bear Stearns. We couldn't help but notice, however, that Thain seemed a bit worried that the Fed isn't going to keep the window open. To paraphrase a popular saying on Wall Street, "hoping" the Fed window stays open is not a strategy.

"I think it should stay available to the banks and investment banks -- the primary dealers. It's important that it does stay available," Thain said to the audience at the Wall Street Journal dealmakers conference at the posh Pierre Hotel in Manhattan.

It had been widely assumed that the facility would be continued after its scheduled expiration in September. But recently opinions have shifted, with some reading the recent warnings from several Fed officials as indicating the window will be closed. What's more, the investment banking community is said to be split on whether they should have continued access to the window. Goldman Sachs is said to be leaning toward opposing a move to make the borrowing facility permanent, and Lehman is said to support the move. Morgan Stanley reportedly takes a middle position, wanting to wait to see the kind of regulation that would accompany the window.

This is the first time we know of that a securities firm has gone on record with its support of keeping the window open. Thain's decision to take this stance seems to indicate that he is taking seriously the idea that the Fed will not keep the facility open beyond September.

Merrill's Thain Urges Fed To Extend Lending Deadline To Brokers [Dow Jones]

Merrill CEO wants ongoing Fed access, rules reform [Reuters]

Yesterday we interviewed an investment banker who thinks the Federal Reserve will permanently close the new facility for borrowing by investment banks when it expires in September. Michael Lewis says its too late, the impression that Wall Street's biggest institutions are too big to fail has already taken hold and cannot be reversed. Regulation will surely follow.

Widespread expectations that the borrowing window opened to investment banks in the midst of the Bear Stearns collapse last March will be made permanent may be misplaced, according to a longtime Fed watcher and banking expert we spoke with today. It may also explain why Lehman was so eager to shore up its balance sheet.

"All the talk coming out of the Federal Reserve about moral hazard and the unique situation we faced in March is meant to signal that the window will be closed," he said over a bowl of gazpacho in a Soho restaurant.

The Federal Reserve is concerned that the widespread impression among Wall Street executives and investors that the Fed now stands behind investment banks may encourage excess risk taking, he said. Many are skeptical that further regulation could effectively stem risks, and fear that further entrenching the Federal Reserve in the financial system could endanger its independence.

Remarks made today by New York Federal Reserve Bank President Timothy Geithner seem to support this idea. "I know that many hope and believe that we could design our system so that supervisors would have the ability to act preemptively to diffuse pockets of risk and leverage," he said. "I do not believe that is a desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of regulation and uncertainty about the rules of the game that would offset any possible benefit."

Lehman's decision to raise $6.0 billion in new capital was driven in part by fear that the Federal Reserve's borrowing window will permanently be closed to investment banks, he said. He believes the Fed has been quietly telling investment banks to expect the emergency borrowing facilities not to be renewed after they expire in September.

Although New York Federal Reserve Bank President Timothy Geithner said today that he supports the Fed's moves to rescue Bear Stearns from bankruptcy, he went out of his way to emphasize that this was a response to an acute risk to the financial system.

"It was the only feasible option available to avert default," he said. "We were not confident that the damage could be maintained by other means."

The Federal reserve has been on something of a yakking rampage lately.

The Fed worked mightily to get rid of the stigma attached to banks going to its discount window. But for its newly minted investment banking fund window, the stigma perseveres. Today Lehman Brothers's treasurer spoke to CNBC to deny speculation that it accessed the Fed's borrowing window, and this denial seems to have lifted the financial sector a bit. That's stigma in action.

Lehman says the last time it went to a Fed facility was April 16. It claims its cash on hand rose $40 billion in the first quarter. But Felix Salmon points out that Lehman's hedging strategy seems to have been destined to fail because they tried to hedge specific positions. When markets behave chaotically, hedges like those attempted by Lehman fail. "We've seen this movie before, most memorably at Bear Stearns," Salmon writes.

As we pointed out the other day, a rift has developed on Wall Street over whether access to funds from the Federal Reserve is worth the price of increased regulation. Lehman Brothers is reportedly willing to accept the regulation while Goldman Sachs is said to oppose it, and is willing to give up access to the new Fed facility if necessary. Tim Carney, who writes for the Washington Examiner and is the brother of one of DealBreaker's editors, takes a look at why the investment banks have split over the issue.

These companies' financial situations give a hint. Goldman, in its most recent quarterly report, showed a positive gross profit, as it had for the years 2007 and 2006. Lehman, meanwhile, posted a $6.6 billion gross loss last quarter.

Goldman, like the whole financial sector, has plenty of headaches, but thanks in part to its correct bet on the housing slowdown and credit crunch, it is thriving compared with its competitors. Subsidized loans will help Goldman, but the weaker sisters in the industry need them more. Regulations may stabilize Goldman's position, but they will keep Goldman from improving that position.

Deal or no deal? [Washington Examiner]

What role did the government play in setting the price for JP Morgan Chase's acquisition of Bear Stearns? The big story in today's Wall Street Journal indicates that regulators may have misled lawmakers on this question.

The last chapter of Kate Kelly's Wall Street Journal epic on the decline and fall of Bear Stearns tells us that the "hurried deal" to keep Bear Stearns out of bankruptcy included a "loophole" that gave Bear Stearns investors leverage to seek a higher price. By now this story of the loophole is well-known, thanks in part to a New York Times front page story that first reported it. In time this story is likely to harden into conventional wisdom, especially now that it's been endorsed by both the Times and the Journal.

Unfortunately, the story probably isn't true.

Ever since the Federal Reserve began allowing investment banks access to a special borrowing facility, there have been predictions and calls for the Fed to start regulating investment banks. Now it seems the investment banks are split about whether access to the emergency window is worth the price of new regulations.

More after the jump.

On Tuesday, March 11, Federal Reserve Chairman Ben S. Bernanke lunched with what Bloomberg is describing as a “Who's Who of Wall Street leaders.” Attendees JPMorgan Chase 's Jamie Dimon, Goldman Sachs’s top dog Lloyd Blankfein, Lehman Brothers boss Richard Fuld, Morgan Stanley President James Gorman, Citigroup’s consigliore Robert Rubin, Blackstone Group’s little big man Stephen Schwarzman and Merrill Lynch’s John Thain.

Guess who wasn’t at the lunch? If you answered “anyone from Bear Stearns” you’d be absolutely right. Now some are speculating that Bear Stearns may have been purposefully excluded because its fate was one of the topics of discussion.

“It doesn't seem credible that just about every major financial institution in the United States, except Bear Stearns, had a meeting about the most pressing issue of the day, bank liquidity, and the subject wasn't about Bear Stearns, who had rumors swirling about them since Monday,” Eric Salzman at the Monkey Business blog says.

What was discussed at the luncheon has not been revealed. Bloomberg News obtained Bernanke’s schedule and the list of attendees in response to a request under the Freedom of Information Act. But the timing seems is jarring. Rumors of liquidity troubles at Bear had prompted the bank to issue a denial the day before for the lunch. On the preceding Friday, one bank (which has not been identified) refused to make a short term loan of $2 billion to Bear. The meeting came hours after Bernanke announced plans to lend $200 billion of Treasuries in exchange for debt including mortgage-backed securities. Hours after the meeting every bank on Wall Street reportedly began refusing to issue credit protection on the debt of Bear. Two days later Bear Stearns chief executive Alan Schwarz would be forced to call Dimon to seek $30 billion in emergency funding.

Update: Was Bear left out because its top two men were out of town? If we recall correctly, Schwarz was down at the Bear Stearns Media Conference in Palm Beach around this time, and chairman Jimmy Cayne was flying out for a bridge tournament in the midwest.

Bernanke Lunched With Dimon, Rubin Before Bear Rescue [Bloomberg]

We’ve finally gotten around to reading the words that the Bearded One spoke at Columbia Business School on Monday night. Stitching together his various proposals, it’s clear that Ben Bernanke has become a partisan of big government. The way we read it, he pretty much calls for the federal government to bailout lenders who have provided mortgages for homes that have suffered major declines in value.

At one point in the speech, Bernanke called on Congress to expand the Federal Housing Administration, both in terms of its role in issuing mortgages and determining underwriting strategies in order to help “troubled borrowers.” How does he expect the expanded FHA to help? By bailing out lenders with mortgages where the principal is now worth more than the value of the home.

“In some cases, when the source of the problem is a decline of the value of the home well below the mortgage's principal balance, the best solution may be a write-down of principal or other permanent modification of the loan by the servicer, perhaps combined with a refinancing by the Federal Housing Administration or another lender,” Bernanke said.

In other words, the Federal government should step in to refinance loans in danger of defaulting due to the decline in housing prices.

When Bear Stearns looked like it would go for $2 a share, there was a lot of sympathy for investors who stood to lose tremendous amounts. Employees—who own about a third of Bear—faced not only losing their jobs but their savings as well. So when they gnashed their teeth and hollered that their firm was being stolen by a conspiracy led by the Fed and carried out by JP Morgan Chase, it was just plain polite not to point out that their firm was on the verge of bankruptcy, that its failures had arguably put the larger financial system at risk and that what little they were getting was the result of a government-led bailout.

But now that the price of the deal has risen to ten dollars and shares are trading even higher than that, the backlash has begun. Writing for Smart Money, James Stewart writes that the protests against the rescue of Bear Stearns from insiders are “galling.” What’s more, it shows the Wall Street is all too willing to seek a government safety net when it stumbles on its free-market high-wire act, he argues. The profits from risk are private, but the losses are all too public.

Having artfully solved a thorny problem a week ago, the government has now embraced a deal whose terms reek of the bailout it was at such pains to avoid. If the government is willing to bestow such a windfall on a James Cayne, where will it it stop? Why should other financial firms reduce risk and shore up their capital? What discipline will the market ever be able to impose? Future disasters will only be worse, which will dwarf the immediate cost of the current rescue.

Yves Smith at Naked Capitalism is even more blunt, and he criticizes the media for being too sympathetic to Bear’s employees and investors. “Bear was going to fail as of Monday,” he writes. “Bye bye equity and many if not most jobs. How hard is this to understand? I thought anyone who was remotely financially literate understood what bankruptcy means. The employees should be grateful to get anything. But no, the media slavishly accepts their sense of entitlement.”

No Tears for Mr. Cayne [Smart Money]
Bear: Did the Fed and Treasury Push Too Hard? [NakedCapitalism]

So the Federal Reserve decided to defy market expectations and the predictions of most Wall Street economists that it would cut 100 basis points from the Fed Funds target rate and delivered only a 75 basis point cut. Economists for Citigroup, Morgan Stanley, Goldman Sachs, Standard & Poors and Bear Stearns all called it wrong.

DealBreaker’s readers did better. The chances of a 75 basis point cut ran neck and neck with the chances of a 100 basis point cut for most the morning and early afternoon. As the Fed announcement approached, however, the votes for a 75 basis point cut pulled ahead. Thirty-nine percent of readers voting in the poll favored 75 basis points, and 34.% favored 100 basis points. Joseph LaVorgna, chief U.S. economist at Deutsche Bank, also called it right by predicting a 75 basis point cut.

The market then also defied almost everyone’s staging a tremendous rally after the news broke. Goldman Sachs had warned that “anything less than the almost [one percentage point] that is now discounted will risk an adverse market response that could aggravate the fragility Fed officials are trying to repair.” Well, at least in terms of the immediate market reaction, that prediction seems dead-wrong.

Why the rally? We don’t like to offer explanations for movements of broad stock market indexes. But we do think the Fed statement probably reassured many investors by re-iterating the Fed’s awareness that the economy is in peril and repeating its new mantra about being prepared to take further action should things deteriorate. What’s more, there was something comforting in the display of a Federal Reserve confident enough to defy the clamoring of the Punch Bowl Caucus. From a Fed that has lately seemed to only ask “how high” whenever Wall Street has said “jump,” those 25 points of defiance are a welcome sign of independent judgment.