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Bear Bailout First, Regulatory Responsibility Second

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Fed's latest action opens discount window to Wall Street.

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Ben Bernanke had a busy weekend.

To facilitate JP Morgan's (JPM) buyout of Bear Stearns (BSC) and save the 85-year-old firm from bankruptcy, the Federal Reserve agreed to lend JP Morgan up to $30 billion and absorb losses on Bear's riskiest assets. The Fed also announced a 0.25% cut in its emergency lending rate and opened the discount window to some non-depository banks last night.

Opening the discount window to primary dealers like Merrill Lynch (MER), Goldman Sachs (GS) and Morgan Stanley (MS) is effectively a bridge loan to allow time for the Fed to establish the $200 billion Term Securities Lending Facility, or TSFL.

Over the weekend, The Wall Street Journal speculated that the motivation of the Fed's involvement in the bailout was not that Bear was "too big to fail," but that Bear's ties to the rest of the financial community were too integral to be left alone. Bernanke is hoping that opening the discount window to Wall Street, while it won't save Bear, will provide the liquidity necessary for an orderly unwinding of the firm's exposure to the multi-trillion dollar derivatives market.

Even talking heads are finally awakening to the fact that we're facing a solvency crisis, not simply a liquidity squeeze. This concept gets a lot of airtime in Minyanville, leading Mr. Practical to question the wisdom of the Fed's use of its own balance sheet to take on risky mortgage assets.

The Fed's engaged in a dangerous battle, one that pits its arsenal of measures aimed at staving off panic against free market forces trying to evaluate the risk the credit crunch poses to the world's financial system. The Fed will try to facilitate orderly price discovery, even as it unloads the last of its precious bullets.


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No positions in stocks mentioned.

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