bearstearns.jpg It’s very reassuring to have an uncle who will back you up on all your risky investments – that is, only if you are his niece . But it must be very disconcerting to know that your uncle is gender-biased and will not back you up if you are his nephew .

But if you are his nephew and do make a risky investment and – lo and behold – your uncle comes to your rescue, then Hooray!! The problem will not be that you will dissolve into bankruptcy, but that all your uncle’s other nephews may come to expect the very same treatment.

Such is the problem of the Federal Reserve Bank.

Investors are generally aware that the Fed acts as a "lender of last resort" to commercial banks who are members of the Federal Reserve System. It does not similarly serve the investment banks (e.g. Citigroup, Merrill, Lehman Bros., Bear Stearns, J.P. Morgan Chase, etc…).

The difference is significant in many ways; very importantly, commercial banks are limited by the Fed in the amount of debt they may incur proportionate to their current equity. Reserve requirements of the central bank specify that (most) commercial banks maintain equity reserves not less than 10% of their total assets. The investment banks, however, unfettered by such a requirement, generally carry much higher – and riskier – debt:equity ratios. For example, Bear Stearns, a recent casualty of excessive debt, carried a debt:equity ratio of 32:1.

Some investment banks carry debt ratios much higher than they appear. Citigroup, for example, carries a ratio of approximately 8.2:1. But Citi has grown in the last few years by acquisitions and the value of the goodwill acquired in these transactions (value of the transaction over and above the market value) adds considerably to the total of assets on its balance sheet. In Citi’s case, subtracting these non-cash items from the asset total shows that Citi’s debt ratio is approximately 42:1.

Most investors know that leverage is the original two-edged sword. Leverage is a great equity multiplier when asset values are increasing, but it can also be a howling demon in periods of asset deflation. Demands for cash from investors and creditors cannot be met with amortization and depreciation allowances.

Bear Stearns found this out when counterparties made – for all practical cases – a run on the firm, demanding a liquidation of their accounts. We now know, as the result of the Fed’s subsequent bailout, that Bear Stearns carries at least $30B in mortgage debt. But in the current liquidity crunch which makes it extremely difficult, if not impossible, to sell assets for their fair market value, Bear Stearns was unable to meet withdrawal demands last Thursday and faced impending insolvency. If Bear Stearns had been allowed to proceed to bankruptcy, the cascading effect among other investment banks would likely have brought down the entire financial system.

Enter Uncle Sam. The rescue of the system was initiated over the weekend by Uncle Timothy F. Geithner, otherwise known as President and CEO of the NY Federal Reserve Bank. James (Jamie) Dimon, a Director of the NY Federal Reserve Bank and President and CEO of J.P. Morgan Chase, was conveniently at hand.

According to the bailout agreement, J.P. Morgan Chase agreed to buyout Bear Stearns for $2.00/share (vs. $84 in book value) in return for a guarantee by the Federal Reserve Bank of up to $30B in Bear Stearn’s debt. Later this week, in response to protests from Bear Stearns’ employees who hold approximately 1/3 of the shares and shareholders, such as Britain’s Joseph Lewis who holds approximately 8 % of Bear stock, Dimon upped his price to $10.00 per share. To placate the Fed, which is sensitive to criticism that it has bailed out a bank that is not a member of the Federal Reserve System, Dimon has agreed to assume the first $1B in losses, if any.

Alea Iacta Est: The Die is Cast.

In expanding its regulatory sphere, the Fed has now poked its nose under the traditional tent of the Securities Exchange Commission. The next financial emergency, which is very probable in view of the high leverage employed by most hedge funds and other investment banks, will raise the question of Uncle’s role. It remains to be seen whether the SEC will contest this regulatory expansion onto its turf or will acquiesce. Odds are that, lacking a means of financial rescue, the SEC will silently steal away. What we can expect, sooner or later, is another bailout by the Fed which will transfer more bad debt onto the Treasury’s books.

In the meantime, Mr. Bernanke’s lowering of interest rates has also severely lowered the returns from savings and CD accounts upon which so many people depend. It has also caused a drastic depreciation in the purchasing power of the earned US dollar spiking commodity prices, food and fuel for the average American. It is hard to overlook the fact that last January the top 5 investment banks (including Bear Stearns) paid out over $39B in annual bonuses.

Once again, Mr. Bernanke has averted a financial disaster, albeit having bent a few rules. The test will come when the next financial emergency arises. There is just so much debt that the Treasury can take onto its books and just so much debt that the U.S. economy and its taxpayers can withstand.