Please see Who's Holding The Bag? and scroll down to the section "Warren Buffett vs. Greenspan" for a clear warning about derivatives.

By the end of his comments, it was also clear that he and the Fed were not entirely pleased with the “blueprint” for regulatory changes issued on Monday by the Treasury secretary, Henry M. Paulson Jr.

That proposal called for an overhaul and consolidation of the financial regulatory system. The Fed chief, in an almost classic case of damning with faint praise, said Mr. Paulson’s blueprint was “a very interesting and useful first step” for Congress to consider.

My Comment: The Fed is angling for still more power. This is a very dangerous situation.

Uncertainty Principle Corollary Number Two: The (quasi)government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they don't know what they're doing.

Mr. Bernanke, making his first public comments about Bear Stearns, spent a considerable amount of time defending the Fed’s actions in arranging for Bear Stearns to be acquired by JPMorgan Chase at a fire-sale price, and with the help of a $30 billion loan from the Fed.

Providing new details about the deal, which was arranged behind closed doors during the weekend of March 15, Mr. Bernanke said he and his colleagues at the Fed did not know until March 13 that Bear Stearns faced bankruptcy and that they quickly realized a failure to act would create a global crisis.

My Comment: I believe the Fed acted illegally. I will have more on this below.

“With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence,” he said. “The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’ thousands of counterparties and perhaps companies with similar businesses.”

My Comment: Clearly the Fed learned nothing from the collapse of Long Term Capital Management (LTCM) to have allowed banks like JPMorgan (JPM) take on trillions of dollars worth of derivative positions.

Uncertainty Principle Corollary Number Three: Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Caroline Baum Blasts Fed Decisions

Caroline Baum hit one out of the park with her assessment of how the Fed handled the Bear Stearns problem. Please consider Fed Should Clarify Link to Bear Stearns Assets.

Watching the evolution of Fed policy in the last six months from focused on inflation to fearful of systemic risk; the series of aggressive, rapid-fire rate cuts; the creation of an alphabet soup of new lending facilities [TAF, TSLF, PDCF]; and the orchestration of a fire sale of Bear Stearns to JPMorgan, one has to wonder about the Fed's M.O. It all has a make-it-up-as-you-go-along quality.

Are the Fed's Actions Illegal?

John Hussman has this to say in his weekly column Why is Bear Stearns Trading at $6 Instead of $2?

The Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns' mortgage debt. But the bank -- J.P. Morgan -- was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.”

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people -- the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the "collateral" would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.

I believe the action and the vote were both illegal. The Fed needs five members to vote on such actions and only four members were present. Fed Governor Mishkin was missing in action. Was he opposed to this illegal hijacking? There was an excellent discussion of this idea in the comments section of the California Housing Forecast.

Uncertainty Principle Corollary Number Four: The Fed simply doesn't care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Let's Recap.

Fed Uncertainty Principle:
The Fed, by its very existence, has completely distorted the market via self reinforcing observer-participant feedback loops. Thus, it's fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed's actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two:
The (quasi)government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply doesn't care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.