Last Updated: March 31, 2008: 1:58 PM EDT
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On the brink of disaster

By Allan Sloan, senior editor at large

The three newbies - the term auction lending facility, the primary-dealer credit facility, and the term securities lending facility - total more than half-a-trillion dollars, with more if needed. Much of this money is available not only to commercial banks but also to investment banks, which normally aren't allowed to borrow from the Fed.

How can the Fed afford this largesse? Easy. Unlike a normal lender, the Fed can't run out of money - at least, I don't think it can. It can manage monetary policy while in effect creating banking reserves out of thin air and lending them out at interest.

That's how the Fed reported a $34 billion profit in 2006, the last available year, of which $29 billion was sent to the Treasury. The Fed can even add to its $800 billion stash of Treasury securities by borrowing more of them from other big players.

Then there's the Treasury. In March the Treasury - which failed this past winter to get private firms to establish a $100 billion "superfund" (please, no giggles from people who equate the term with Love Canal) to keep things called "structured investment vehicles" from having to sell their holdings in a bad market - unleashed Fannie Mae (FNM) and Freddie Mac (FRE, Fortune 500) and the Federal Home Loan Banks to buy hundreds of billions of dollars of mortgage-backed securities.

That market was seeing prices drop sharply because of large forced sales from the collapse of Carlyle Capital and from hedge funds desperate to pay off some of their borrowings. That decline, in turn, could have forced more write-downs at big firms. Bringing Fannie and Freddie back in the game eases those market problems. Letting Fannie and Freddie bulk up could create trouble down the road, the firms' pledges to raise more capital notwithstanding. But on balance, it was a smart thing to do.

How you'll pay

Still with me? Good. Now let me show you how we taxpayers are picking up the tab for much of this rescue mission to the markets - even though Uncle Sam isn't sending checks to Wall Street. Here's the math. Say the Fed extends $500 billion of emergency loans to firms in need of short-term money. They're paying around 2.5% interest to Uncle Ben (or Uncle Sam, if you prefer). That rate is way below what they'd pay to borrow in the open market, if they could borrow. The difference between the open-market price and 2.5% is a gift from us, the taxpayers.

I think that's better than letting the world financial system collapse - but it's a serious subsidy to outfits that made a lot of money on the way up and that are now whining about losses. You gotta love it - private profits, socialized losses.

Now to the infamous Bear Stearns deal. Bear shareholders are set to get $10 a share - about $1.2 billion - from J.P. Morgan Chase (JPM, Fortune 500). That's $1.2 billion more than they were likely to realize in a bankruptcy had the Fed and the Treasury dared let Bear go broke. More important, Bear's creditors - who were asleep at the switch and ought to be forced to pay for it - got out whole because J.P. Morgan agreed to take over Bear's obligations.

The only reason Morgan did that is its deal with the Fed. The Fed is fronting $29 billion to Bear, which in turn will offload $30 billion of its financial toxic waste into a fund run on the Fed's behalf. J.P. Morgan eats the first $1 billion of losses - a concession it made to the Fed, which was embarrassed and enraged when Morgan raised the price it was paying for Bear to $10 a share from the $2 originally agreed to.

The securities that Bear is shedding aren't worth $29 billion in today's markets -if they were, Morgan wouldn't need the Fed's dough. The Fed - which is to say the taxpayers - is eating the difference between $29 billion and what that stuff is worth. It wouldn't surprise me to see the Fed end up with a $4 billion haircut - but we'll probably never know. (Once you take that haircut into account, you see why Bear shareholders should stop complaining about getting "only" $10, and why Bear debtholders should erect a statue to Bernanke.)

Fedniks tell their friends - yes, many Fed folks have both social consciences and friends - that they're furious about the Wall Street enablers of the mortgage mess and other financial excesses being able to escape the full cost of their folly, with the public picking up the cost.

The lesser evil

But as one of the players said to me, "Is it better to let Bear Stearns fail and risk setting off a market collapse that costs a million jobs?" The answer, of course, is no. Bear had about $13 trillion of derivatives deals with counterparties, according to its most recent financial filings. If Bear had croaked, large parts of the world could have croaked. And the economic damage could have been catastrophic.

Okay. Is there good news here? Indeed, there is. Sooner or later, all this money being thrown at the debt markets will stabilize things.

But the costs will be steep. Those of us who have been prudent, lived within our means, and didn't overborrow are paying a huge price for this. Income on our Treasury bills, money market funds, and CDs has dropped sharply, thanks to the Fed's rate cuts, and our wealth has eroded relative to foreign currencies and commodities.

As an indirect result of the Fed cutting short-term rates, we've already seen a loss of faith in the dollar by our foreign creditors. That's helped run up the price of commodities that are priced in dollars, and may well be stirring up inflation even as the Fed lowers retirees' incomes.

It's going to get harder and harder to finance our country's trade and federal budget deficits, with our seemingly ever-falling dollar carrying such low interest rates. The dollar has been the world's preeminent reserve currency - but I think those days are drawing to a close. Don't be surprised if in the not distant future the U.S. is forced by its lenders to borrow in currencies other than its own. It could get really ugly.

Our financial institutions will emerge from this episode weakened, compared with those in the rest of the world. It's going to take years to work out our country's excess borrowings, with lenders and borrowers - and quite likely American taxpayers all bearing the cost.

So, after all this, we end up with the same old story. Whenever you see a financially driven boom and people tell you, "This time it's different," don't listen. It's never different. Sooner or later, the bubble pops, as it has now. And you and I end up paying for it.

For more commentary by Allan Sloan, go to fortune.com/sloan.

Reporter Associate Doris Burke contributed to this article. To top of page

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