WASHINGTON-Few question the Federal Reserve Board's recent efforts to stabilize the economy, but plenty of people are wondering how much risk the central bank is taking.

In the past week, the Fed has agreed to put up $30 billion to facilitate Bear Stearns Cos.' takeover by JPMorgan Chase & Co.; opened the discount window to investment banks it does not supervise; and broadened the scope of acceptable collateral for liquidity auctions to include mortgage-backed securities.

The Fed turned down requests to detail how much risk it is taking or estimate possible losses on the backstop it is supplying for JPMorgan Chase. The agency said that the securities it would accept as collateral for discount window cash are all investment grade, and that it would require borrowers to take a haircut on collateral pledged.

But officials would not detail how they plan to value assets or the formula they would use to calculate the haircut.

That reticence is leading to some polite second-guessing, as well as some blunt criticism.

"The main risk is if the crisis continues and we have a plunge in the markets, that the collateral turns out to be not very valuable," said Alice Rivlin, a former Fed vice chairwoman who is now a senior fellow at the Brookings Institution. "The Fed is staking its reputation as a central bank here on something that might not work."

Josh Rosner, a managing partner at Graham Fisher & Co. Inc., echoed that sentiment: "Put aside the question of whether it's the right policy move or not," he said. "The more pressing question, given the fact that this is a taxpayer-borne risk, is shouldn't the Fed be required to actually disclose the terms. There should be a requirement that they disclose it at some point, because these are taxpayer dollars."

The Fed's decision Sunday to lend JPMorgan Chase money to cover losses embedded at Bear Stearns has some critics scratching their heads.

"The irony is that we have gotten into this mess by lenders' willingness to lend to institutions without considering repayment ability, and yet it seems that may be what the Fed is doing," Rosner said.

Sources said the Fed should disclose specific terms of the loan, such as its interest rate and fees.

Serious Questions On Transparency

"It''s very concerning," said Gil Schwartz, a former Fed lawyer who now works in private practice as a partner at Schwartz & Ballen LLP. "The Fed and the other agencies have been saying we need transparency in the financial system, and now it's like, What's the deal here?' I think you have to assume the Fed will take a $30 billion loss" on the loan.

Brian Gardner, an analyst with KBW Inc.'s Keefe, Bruyette & Woods Inc., said the Fed also has put itself in the unusual position of managing credit risk.

"Most of the risk they've taken in the past would be considered interest rate risk, since it was so short-term," Gardner said. "Now they're getting into credit risk. That's a different kettle of fish and brings on different issues. We'll now find out what kind of expertise the Fed has in managing this."

In Congressional testimony this month, Fed Vice Chairman Donald Kohn acknowledged that expanding the window beyond commercial banks could "carry some very major costs," because the central bank does not supervise directly the 20 investment banks it has invited to borrow from the discount window for at least six months.

Rosner questioned the Fed's assurances that all the assets it accepts as collateral would be investment grade.

"We all know that much of this highly rated collateral will ultimately be worthless," Rosner said.

"The Fed is relying on its own clients' view that these assets are now being underpriced in the market, and that is the root of the problem-that they are still good credits that are being underpriced. That line of reasoning undermines the Fed's belief in free markets, because investors obviously disagree, or they wouldn't be underpriced," he said.

Lou Crandall, the chief economist at policy analysis firm Wrightson ICAP LLC, said the Fed will have to make some adjustments in working with companies that often play under different rules than the ones governing commercial banks.

Different Ballgames

Securities firms are regulated differently from banks, and they are encouraged to be prudent on one hand, but they take risks that would not be acceptable to a banking organization," he said. "Securities firms are not required to be as soundly capitalized."

Of course, some sources defended the Fed, saying that any hit it takes would be merely the cost of protecting the economy.

"We are putting out a fire, and we have to do what we have to do now to instill confidence in the system," said Ken Thomas, a lecturer in finance at the University of Pennsylvania's Wharton School. "This is not the time for armchair discussions of Federal Reserve and counterparty risk."

But Donald Mullineaux, a banking professor at the University of Kentucky, was representative of a number of sources interviewed for this story. He said that no one, including the Fed, knows how to value assets for which there is no market.

Cracking the Credit Crunch

And therein lies the long debated issue of fair-market valuing instruments in the mutual fund industry. Even the savviest experts, from the front office all the way to the inner workings of the back office, have difficulty valuing many of the instruments held in mutual fund portfolios, as Money Management Executive has chronicled.

"We don't know what the Fed is on the hook for," Prof. Mullineaux said. "In a transparent world, they would tell us, but I'm not sure that will happen."

The Fed's first move on this front came in December when it unveiled a term loan auction to sell cash to bidding financial institutions. Since then it has initiated two separate programs designed to lend $200 billion each in a move to crack the credit crunch. The collateral backing these programs is considered less risky than the discount window lending just announced. The Fed is scheduled to release its latest figures on discount window volume on Thursday, following deadline for this story.

- Todd Davenport contributed to this story.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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