Making sense of this bizarre market

By Jim Jubak

The stock market spends days edging lower but then stages an explosive rally. Wall Street is on the edge of panic, but the Federal Reserve keeps pulling the bankers in from the ledge. One day Bear Stearns (BSC, news, msgs) drops $26 a share and then gets "rescued" for $2 a share. The next day shares of Goldman Sachs (GS, news, msgs) climb $24.57.

What's really behind the market's wild gyrations? Have we put in a bottom near the January 2008 lows? Or are we just one piece of bad news away from a full-fledged bear market?

To answer those questions, think of what the stock market has been through in the past 10 days as something like a giant margin call.

You know what a margin call is, right? It's when a broker -- or indeed anybody who has lent you money to buy stocks, bonds or derivatives -- demands that you put up more collateral for your loan because a falling market has wiped out part of the value of your original collateral. If you can't meet the call, your lender sells whatever you own.

Why there's such panic

In today's market, because no one is sure who owes what to whom (yes, derivatives are that complicated) and because no one is sure what the very thinly traded assets in the typical Wall Street portfolio are worth, Wall Street behaves at the slightest sign of trouble as if it were going to receive a massive margin call. It sells everything, especially its winners, in a panicked rush to pile up the cash it would need just in case the next time the phone rings it is a real margin call.

The effect is to turn modest downturns into panic selling that takes down all sectors, the relatively strong and the relatively weak alike. In recent weeks, this panic selling has pushed the stock market to a series of ever-so-slightly lower lows.

When the panic passes -- when Wall Street concludes the danger of a margin call is over -- stocks recover, as it did Tuesday, March 18, in the run-up to the Federal Reserve's three-quarter-point interest-rate cut. Think of that rally not as a sign that everything is all right but as a measure of Wall Street's fear that the world might be coming to an end -- and its relief that it didn't.

A look at the machinations

I'm calling it the "margin-call market," and here's how it works:

Propped up by a flood of cash from the Fed, Wall Street wants to hang tough. The players are sitting on huge piles of very thinly traded securities based on residential and commercial mortgages and buyout loans, or of tough-to-price derivatives designed to hedge the risk of these assets. The prices of these assets have been hammered, and even if a Goldman Sachs or Morgan Stanley (MS, news, msgs) has written them down to market on its books, nobody wants to actually sell at today's prices.

There's still faith, expressed by folks like the CEO of American International Group (AIG, news, msgs), that today's write-offs can turn into tomorrow's profits as prices recover. Every day that goes by without a financial market meltdown encourages the guys and gals who run the banks, the nonbank banks, the big trading houses, the market makers and the hedge funds to believe they might still be able to get by without selling the assets in their portfolios at current fire-sale prices.

But they're spooked. They see what happened to Bear Stearns when a company that claimed assets with a book value of $80 a share on March 14 was unable to raise cash on those assets. All Bear Stearns really needed was time -- time for the Fed's new lending programs to kick in, time for buyers to return to the markets for the assets it held and time for the price of those assets to recover.

But no one wanted to risk the survival of their own company by giving Bear Stearns more time. Making a loan when you don't know when or if you'll be repaid, at a time when your own company could get a demand for cash from creditors or investors, put too much on the line. With demands for cash rising and the sources of funds drying up, Bear Stearns wound up being sold off in a deal orchestrated by the Fed to JPMorgan Chase (JPM, news, msgs) for $2 a share March 16.

The stampede to raise cash

The speed of that collapse was absolutely breathtaking and very, very frightening.

And the lesson the Wall Street players have drawn from that is "sell early." At the first sign of trouble. Before the market seizes up and you can't raise cash. Undo loans you've made because you don't know who will be able to pay them back. Pay back money you've borrowed so that no one can force you to pay it back on their schedule. Raise cash and sit on it.

Continued: Expectations of lower lows

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