They are worried about a ‘liquidity trap’

Economics Blog : Fed Invokes Depression-Era Law for Bear Loan

Key sentence:

Officials said while the loan is being made via J.P. Morgan Chase, the risk is being borne by the Fed. That means if Bear Stearns fails and the collateral is insufficient to repay the loan, the Fed would incur a loss.

This only makes sense (to me) if the Fed thinks that the underlying assets are good, but that the market is over-reacting so that the Fed needs to break a panic.

Here is a relevant paper:
Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?

Abstract:

The classical doctrine of the Lender of Last Resort (LOLR), elaborated by Bagehot (1873), asserts that the central bank should lend to “illiquid but solvent” banks under certain conditions. Several authors have argued that this view is now obsolete: in modern interbank markets, a solvent bank cannot be illiquid. This paper provides a possible theoretical foundation for rescuing Bagehot’s view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We built a model of banks’ liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot find liquidity assistance in the market. We derive policy implications about bank-ing regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort. Furthermore, we find that public (bailout) and private (bail-in) involvement are complementary in implementing the incentive efficient solution and that Bagehot’s Lender of Last Resort facility must work together with institutions providing prompt corrective action and orderly failure resolution. Finally, we derive similar implications for an International Lender of Last Resort (ILOLR). (JEL: G21, G28) Copyright (c) 2004 by the European Economic Association.

Deal done:
JPMorgan closes deal on Bear Stearns – Yahoo! News

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