The Federal Reserve Bank of New York's newly unveiled portfolio of former Bear Stearns assets offers a unique window into the workings of the biggest crisis to hit Wall Street in 80 years.

The 131 pages of Cusip numbers and their dollar amounts, pored over by analysts since their release last Wednesday, raise as many questions as they provide answers about the risks U.S. taxpayers absorbed when the Fed engineered JPMorgan Chase & Co.'s (JPM) rescue of Bear Stearns Cos. in March 2008.

But as a snapshot of Bear's balance sheet at its most distressed moment, the Fed's holdings in Maiden Lane LLC--the special-purpose vehicle that was followed by two others used in the bailout of American International Group Inc. (AIG)--also provide insights into what went wrong, both at that fated firm and on Wall Street in general. Bear's experience was emblematic of practices that were widespread in the industry, and which resulted in many more bailouts and government-assisted takeovers in the months that followed. The difference is that, in Bear's case, we now have a chance to view its dirty laundry.

The portfolio, which has a notional value of $74.8 billion but which is valued on the Fed's balance sheet at just $27 billion, offers a picture of how structured finance led investment banks away from their standard intermediary role to one in which they held large long-term positions on their balance sheets.

In this structural shift, "people who were sociologically used to being agents became principals," said Terry Connelly, dean of the Ageno School of Business at Golden Gate University in San Francisco. "And they were amateurs at it."

Because these investment banks didn't have access to the government-insured deposits that backstop commercial banks, their actions eventually put the entire financial system in grave danger.

"You can only understand Bear Stearns' balance sheet if you understand an idea that's culturally ingrained on Wall Street, and that is that prudence is for wimps," said Connelly, who worked at Salomon Brothers during that legendary investment bank's bond-underwriting heydey in the 1980s.

Originally, investment banks made their money by buying up mortgage loans, packaging them into securities, then selling them on to third-party investors. That meant their risk was limited: While interest rates could go against them--a sharp rise could have made a package of loans suddenly unprofitable--such adverse moves could be easily hedged. Hedges weren't required for long periods as the securities were moved quickly off the firms' books.

As market participants liked to quip: Investment banks were in the moving, not in the storage, business.

But then came collateralized-debt obligations, the multi-tiered securities which divvied up different levels of risk from the same pool of underlying assets--effectively giving investors a choice of where they wanted to stand in the queue for repayment on a bond and of what price they would pay for that privilege.

Amid the boom, yield-hungry investors started to shun the safest tranches of those CDOs, the "super-senior secured" tiers. And in a fatal move, investment banks opted to keep them on their books: Since the securities were insured by AAA-rated monoline insurers and, thus, assigned AAA ratings of their own, the banks felt comfortable holding on to them. The only problem was that they tied up capital. And for that, another innovative solution was found: The credit default swap, or CDS, which allowed the banks to offset their exposure to the CDO assets.

This is why, at the bottom of the Fed's Maiden Lane report, more than 1,700 CDS contracts are listed.

If all the CDOs and CMOs (collateralized mortgage obligations) in the Maiden Lane holdings functioned as Bear Stearns' inventory for servicing client demand--rather than deliberate long-term positions--the bank could have used a broad tradable index as a hedge rather than individual credit default swaps. The former would protect the entire portfolio and should in theory be cheaper and more efficient.

One person familiar with Bear Stearns' strategies rejects that argument. He said that the only available index for such hedges at that time--Markit's ABX index of subprime mortgage CDS--was so illiquid and volatile that it "proved to be quite a dangerous hedging mechanism."

But whatever the reason for buying CDS contracts, they, too, proved to be a flawed, if not equally dangerous, hedge when the subprime mortgage bubble burst. As the crisis gathered pace, the insurers lost their triple-A ratings, which led to the downgrades of the super-senior CDO tranches.

This sealed Bear's fate: It sought to offset that loss by buying corporate credit protection--as evidenced by the long list of "corporate" CDS in the Maiden Lane portfolio.

Most of these carry names showing "MBIA Insurance," "Ambac Assurance" or "Financial Security Assurance"--monoline insurers. These were insurance contracts designed to protect Bear Stearns from a default by the institutions that were insuring the rest of their portfolio.

The problem was that the vicious cycle of downgrades had by then infected the counterparties to those and every other CDS--most significantly, AIG.

That's why, in March 2008, the Fed--the only risk-free counterparty--had to step in, setting a precedent that would be repeated frequently in the dramatic months that followed.

-By Michael Casey, Dow Jones Newswires; 212-416-2209; michael.j.casey@dowjones.com
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