More scrutiny ahead

The credit crisis has taken financial regulation into a new era.

The Federal Reserve lent $30 billion to help guarantee the debts of failing investment bank Bear Stearns over the weekend, but it also took a larger, riskier step: deciding to allow other big brokerage firms to borrow directly from the central bank if necessary.

The change marks one of the largest expansions of the Fed's role in its 95-year history, making the government -- ultimately the taxpayers -- the final backstop not just for the nation's banks but for its major investment houses as well.

The emergency action underscores the seriousness of the financial panic affecting Wall Street, which some observers believe holds the threat to collapse the ability of banks and brokerages to borrow and lend. The Fed is expected to follow up today with another large cut in a key short-term interest rate -- perhaps a full percentage point -- intended to make it easier for consumers to borrow.

But quieting the financial panic may require further cuts, and even larger infusions of cash.

"We are talking very, very big numbers," said Nariman Behravesh, chief economist at the economic consulting firm Global Insight.

The tradeoff for the financial services firms may be much stricter federal oversight of their operations than they have experienced.

Goldman Sachs, Morgan Stanley, Lehman Bros. and other big Wall Street investment houses are considered financially stronger than Bear Stearns. But in opening a $200 billion borrowing facility to those firms in addition to commercial banks, the Fed has acknowledged the heavy pressure Wall Street is under from bad mortgage-linked securities.

Under the program, the financial firms will be able to swap mortgage-based securities that no one wants to buy for Treasuries, providing them with a readily saleable asset. While the deals are temporary, they may be rolled over again and again until they no longer are needed.

And that could be a while. Goldman, for example, has roughly $156 million in mortgages on its books.

In return for the Fed's help, the investment banking giants are likely to become the targets of new attempts at regulation that would subject them to the same scrutiny as commercial banks, including audits, extensive financial reports and discipline by government watchdogs, said David Wyss, chief economist at Standard & Poor's.

"If the Fed is going to be on the hook for what these guys do they're going to want to have a say in what risks they take," Wyss said.

"The Federal Reserve cannot afford to rely on a rating agency," Wyss said. "They need to make their own independent judgment."

For the Fed, the decision to include investment banks in access to emergency funds represents a difficult choice between exposing the public to new financial hazards through possible bailouts or to a possible market meltdown if it did nothing.

Investment banks essential

In many ways, investment banks have become more essential to the health of the economy than traditional banks. By the Fed's estimate, in January, $1.3 trillion in consumer credit was tied to finance companies, non-financial businesses and pools of debts that were transformed into securities. Commercial banks, in contrast, accounted for $809 billion in outstanding consumer debt.

The investment banks also play the lead role in raising capital for the new stock and debt offerings that many companies rely on to finance growth and acquisitions.

"I get worried about a regulatory system in which the regulators are so damned conservative that nothing new ever happens," said Prescott, formerly a professor at the University of Minnesota and now a consultant to the Federal Reserve Bank of Minneapolis.

That could lead to monopoly power -- and profits -- for incumbent financial players, he said.

"I hope Bear Stearns executives and stockholders lost everything," Prescott added.

Not quite, but close. Bear Stearns stock closed at $4.81 a share Monday, down $25.19. In the last year, the stock had traded as high as $159.36.

With the Fed now moving to shore up other investment houses with trillions of dollars of their own transactions in play, nervous market watchers have new reason to worry about the ultimate outcome, and how the system can be made more sound.