Why is Wall Street going crazy?

By Charley Blaine

The stock market has been trading violently up and down every day recently.

The Dow Jones Industrial Average ($INDU) has gained or lost more than 100 points on 14 days since the blue-chip index peaked at 14,000 on July 19. It dropped as much as 343 points by 1 p.m. Thursday -- and recovered nearly all of it by the close. Even so, stocks are off nearly 10% since July 19.

And Friday was just as wild, thanks to the Federal Reserve's decision to cut its discount rate from 6.25% to 5.75%.

The Dow jumped more than 320 in the first half hour of trading. And while it gave up some of those gains, it still had a very big day with a gain of 233 points.

So why is there so much volatility? And why now? Here are some of the forces behind the sell-off, the wild gyrations and why it may be a while before the market finds a bottom.

• Dow jumps 233 on Fed's discount-rate cut

First, three reasons for the sell-off:

1. The problems of the subprime market

In early August, players in the global financial markets finally realized that no one really knows the depth of the problems in the subprime mortgage mess.

Not only have loans gone bad, but the securities sold to finance those loans were sold to buyers here and abroad who didn't understand what they were buying.

Since no one knows how long the housing and construction slump will last, valuing securities based on mortgages is nearly impossible. That makes investors vulnerable to every piece of news related to subprime mortgages.

2. The seize-up in the credit markets

The bond salesmen who used to count on College X in Wisconsin, Pension Fund Y in Germany and Bank Z in Asia to buy their securities -- whether mortgage-backed bonds or bonds for leveraged buyouts -- have been told, "No way."

At least not without more return for the risk and certainly not without more disclosure about what's behind the bonds.

This was the reason for the Fed's action on Friday. The Fed saw that the credit markets were in serious disarray, economist Peter Morici of the University of Maryland said on Friday.

And the central bank felt compelled to say it was prepare to help the financial system weather the storm.

3. It's time

The sheer fact of the market's stunning rally since the summer of 2006 improved the odds of a big market sell-off.

The Dow jumped 30% between July 17, 2006, and July 19. The Standard & Poor's 500 Index ($INX) jumped 25.8%; the Nasdaq Composite Index ($COMPX) soared 34%.

Since October 2002 the market has been rising so solidly, with hiccups now and then (and this year's sell-off may still prove to be a hiccup), that many investors began to take market gains as a given.

When that happens, a market often becomes vulnerable to a shock. That's what has occurred since July 19. After Thursday's wild finish, the Dow was off more than 8.2% from that July high. The Nasdaq and the S&P 500 were off 9.9% and 9.1%, respectively, from their July highs.

Yet those forces don't explain the huge swings the market has seen during the last month. Here are some reasons:

The ballooning of debt is exacting its revenge

If you buy a stock for $50 and sell it for $100 a year later, you've made 100% on your money. If you add $25 of borrowed money to $25 of your own to buy the stock at $50 and sell the shares at $100, your profit is $50, but you've made 200% on your $25.

Now let's say you put up $50 and borrow an additional $50 to buy a stock at $100. The stock falls to $25. Your real loss is $75 -- the $50 you have to pay back and the $25 additional loss that you suffered from the fall of the stock's price.

That's what hedge funds have been doing for the last five years. For example, the Goldman Sachs' Global Equity Opportunities Fund was organized with $6 of borrowed money for every dollar raised from investors.

But generally the bets were made assuming that interest rates would remain low. Maybe not as low as 1% -- the level to which the Fed cut its key federal funds rate in June 2003.

But the Fed started to move that key rate -- what banks charge each other for overnight loans -- higher in June 2004. Even if the current level of 5.25% isn't high compared with the 1980s, it's high enough to upset many investors' projections.

When the market turned down, the fund's big profits became big losses. Goldman Sachs (GS, news, msgs) was forced to raise $3 billion to shore up that $6 billion fund, which had managed to shed a third of its value last week.

New rules for selling shares

Earlier this year, the Securities and Exchange Commission voted to kill a rule in place since the 1929 crash that said you couldn't sell a stock short until the price actually rose.

The SEC ended the rule on July 6. Now you can sell a stock short as soon as you want, a change that may have made the market more fickle.

Pack mentality clobbered the quants

Some of the most profitable and fastest-growing hedge funds -- at least until recently -- have been so-called quantitative funds. These funds were built using computer models that look for every price anomaly in the markets. The idea is for the computer to see the discrepancies and make lightning-fast moves to lock in the profit.

The problem is that the people designing the models all know each other, and their models are often similar, said Ernest Chan, a trading consultant, told The New York Times this week. When things go south for one fund, they go south for a lot of funds all at once.