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Federal Reserve Gives Up Bailout Powers (Update 1)

Updated from 9:33 a.m. ET with comments from Frank Mayer, a partner in the Financial Services Practice Group of Pepper Hamilton in Philadelphia.

NEW YORK ( TheStreet) -- The Federal Reserve has proposed a harsh limiting of its own powers to decide on quick extensions of emergency credit to companies, as required under the Dodd-Frank bank reform legislation of 2010.

Prior to Dodd-Frank, the Board of Governors of the Federal Reserve System could approve an extension of credit by a district Federal Reserve bank as long as the borrower was "unable to secure adequate accommodations from other banking institutions."

An example of this type of bailout was the March 2008 agreement to provide a loan of $25 billion to Bear Stearns by the Federal Reserve Bank of New York, which was meant to help the investment bank continue operating for a short period when its liquidity dried up.  That bailout didn't actually materialize, since Bear Stearns was quickly snapped up by JPMorgan Chase (JPM - Get Report) for a fire-sale price, but the Federal Reserve Bank of New York did provide financing for the JPMorgan deal.

The New York Fed also participated in the epic $182.3 billion bailout of American International Group (AIG - Get Report) during 2008 and 2009, although the U.S. Treasury, through the Troubled Assets Relief Program (TARP) and the central Federal Reserve bank provided the bulk of the financing.  According to the Treasury, all the parties bailing out AIG -- including taxpayers -- ended up with very significant profits.

Under the new rules proposed by the Fed on Monday, the Fed Board of Governors will no longer be allowed to approve emergency extensions of credit by district Federal Reserve Banks without the approval of the Secretary of Treasury.

While there has been plenty of cooperation between the Fed and the Treasury through the credit crisis and its aftermath, this represents a major limiting of the central bank's ability to make quick independent decisions in the midst of a liquidity crisis.

A crisis along the lines of the Long Term Capital Management liquidity lockup during 1998 is not the type of systemic liquidity crisis we saw after the U.S. residential real estate bubble collapsed in 2008. The Federal Reserve Bank of New York organized a rapid $3.6 billion bailout of Long Term Capital, which was completely funded by most of the big banks on Wall Street. 

The Bear Stearns blowup, which happened at an early stage of the credit crisis was another situation in which quick decision making was needed.  There's no way of knowing whether or not that type of process may be slowed down under the new rules, because there is no way of predicting whether or not subsequent administrations may be ideologically opposed to any sort of "bailout."

Another major change under the proposed rules is that the Fed will not be able to organize bailouts of individual companies. Instead, the central bank's emergency lending authority will be limited "to extending credit to participants in a program or facility with broad-based eligibility."

This means no more Bear Stearns-like deals. Instead, the Fed has to set up an entire program to allow companies not suffering from immediate liquidity crises the same opportunity to borrow as the stricken entity or entities the Fed determines should be bailed out to stave off risk to the entire financial system.

The Federal Reserve said the proposed rules were developed "in consultation with the Treasury Department" and that the public comment period on the rules would end on March 7, 2014.

It would appear that the days of quick emergency measures by the Federal Reserve Bank of New York during times of unanticipated liquidity lockups, are over.

"There became a thought in Congress that the Federal Reserve was benefiting individual financial institutions, rather than using the emergency power it had to avoid systemic issues," according to Frank Mayer, a partner in the Financial Services Practice Group of Pepper Hamilton in Philadelphia.

According to Mayer, Dodd-Frank switched the emergency bailout authority "to the executive branch, where there is some congressional oversight," while requiring plenty of other measures to shore-up the financial system, including "capital augmentation and also the stress testing and resolution planning and specific coordinated resolution authority of the Federal Deposit Insurance Corp."

But there could eventually be negative consequences to the hobbling of the Fed.

"In my view, Congress has damaged the macro system in reducing the power of the Federal Reserve and that independent check on the executive branch," Mayer says.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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