Emma Trincal, HedgeWorld.com Staff, New York.

The announcement by JP Morgan & Co. on 24 March that it had sweetened its bid for Bear Stearns to $10 per share from $2 per share signaled JP Morgan’s eagerness to close the acquisition. But to many it has been the US Federal Reserve and, more specifically, the New York Fed, behind what many call the Bear Stearns bailout. That, they say, sets a dangerous precedent that could lead to moral hazard.

‘Whether the price was $2 or $10, the Fed is effectively doing a bank bailout. If they need to, they’ll do it again,’ said Alex Allen, chief investment officer at London-based fund of funds Eddington Capital Management Ltd., in an interview. ‘If you have extreme greed, somewhere down the line, you should pay the penalty. And Bear was greedy in that they had a highly-leveraged balance sheet and invested in an extremely risky asset class. One or two banks should go bankrupt. It may create systemic risk short-term, but it would send the right message that you can’t conduct your business recklessly and expect the taxpayer to pay for it.’

In response to this moral hazard charge, US Treasury Secretary Henry Paulson, who worked closely with the Fed in brokering the first deal at $2 per share, so far has responded by pointing to the pain being felt by Bear Stearns' shareholders and asking how anyone can say the Fed is bailing out Bear Stearns.

This argument has lost some of its pertinence now that the deal has been sweetened five-fold to $10 a share. In midday trading on 25 March, Bear’s share price was $10.70, a sign that the market is starting to agree with the new offer. Perhaps to alleviate the anti-Fed argument, the amended deal proposes to let JP Morgan shoulder the first $1 billion of any losses associated with Bear’s problematic mortgage portfolio. The total size of that portfolio is $30 billion. Critics continue to say, though, that the Fed is bailing out the bank, whether it takes on $29 billion or $30 billion in risk exposure.

As a result, the renegotiated agreement seems to signal two things.

First, JP Morgan needed to make the deal happen. ‘The share price was trading above the $2 price for most of the past week and the likelihood of a counterbid from shareholders and employees was mounting,’ said David Hendler, analyst at fixed-income research firm CreditSights Inc. In the new version, JP Morgan will be able to buy 39.5% of newly issued Bear Stearns shares. This new provision leads many to believe that the purchase of Bear Stearns by JP Morgan is now a done deal.

But a cloud remains over the Fed. And the question of whether, by stepping in, the US central bank is avoiding a systemic meltdown or setting a dangerous precedent that will incite banks to continue poorly managing their balance sheets, remains unanswered.