Sell stocks while the selling's good

Darwinian dilemmas

Two recent victims of this practice have shocked the world of high finance: Peloton Partners, run by two former Goldman Sachs (GS, news, msgs) partners in London and celebrated as fixed-income fund of the year for earning over 86% in 2007, and Carlyle Capital, a spinoff of one of the world's most powerful private-equity firms, Carlyle Group.

Peloton couldn't meet margin calls from its prime brokers, including Goldman Sachs, and was shut down Feb. 28. Carlyle Capital, which had leveraged $680 million in real capital by 32 times into a $21.8 billion fund, has failed to meet repeated margin calls and is on life support as partners look for quarters and dimes under the seats of their Bentleys.

It's a little hard to believe that brokerages would force their best clients into ruin, but that is the emblem of the current panic. Think of it as a form of extreme economic Darwinism, as brokerages decide that it's better to cut their customers' throats than to face the executioner themselves.

Remarked one veteran bond market strategist: "Regulators have set up all these rules about margin to give the little guys in the stock market the impression that investing is on the up and up, but there's nothing like that in bonds. That's just the way it is -- welcome to my world. A broker will give you 32-to-1 leverage today, but the trade goes 3% against you, they'll cut you off at the knees."

The strategist, who asked that I not use his name, said equity investors need to understand two points about what's happening in the land of credit:

• One is that the extreme level of borrowing that pushed the market to new highs last year (via leveraged buyouts, corporate share buybacks and the momentum style of trading) is gone. "You only get one chance like that in a generation," the strategist said, laughing. "That money ain't comin' back."

• The other is that debt panics can last a lot longer than anyone expects because there are only a couple of exits in a crowded room. The strategist notes that dozens of billion-dollar funds had identical trades, and they're all trying to get out of the same securities at the same time in a market with no bids. Unlike stocks, which represent the earnings streams of companies that file quarterly reports, asset-backed bonds and the collateralized debt obligations into which they're packaged are opaque, hard-to-value instruments originally sold person to person in private placements where no illusions of transparency or disclosure are even attempted. "The lack of transparency is why credit panics are never a one-day or one-week deal," the strategist said. "They last until everyone is out of the room. It could take months. Could take a year."

In this context you can think of the Fed's move Tuesday to accept $200 billion in AAA-rated securities from banks and brokers in exchange for Treasurys as little more than a modest money-laundering scheme. Although it is accepting mortgage-backed securities for the first time, the Fed isn't taking any of the really bad stuff that's gotten investors into trouble, and its bond whitewashing service will last only a month. It buys time more than anything else.

Switching metaphors, the world financial markets right now are like high-stakes poker games in Las Vegas, and the casino's largest players are on the ropes. Recognizing that they are in trouble, and not wanting the game to end early, the house has decided to act like the world's biggest pawnshop. The players have already pawned their gold Rolexes. Now the Fed is accepting their wives' wedding rings -- but no houses, cars or boats. Maybe after the next hand.

At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column.

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