INVESTING: Investors’ margin calls accelerated selling spree

After a tumultuous and historic couple of weeks, culminating Oct. 10-when stocks dropped 800 points as the market opened-investors stood on the edge of the abyss and stopped selling. Market participants arrived at the conclusion that, over that coming weekend, financial chiefs around the world would do whatever it took to rescue the financial system.

And they did, by formulating measures to be undertaken by finance leaders across the globe that are unprecedented and wideranging, from supporting the commercial paper market, to injecting capital and taking ownership positions in selected banks. In effect, governments around the world have served notice that they will take whatever action is necessary to guarantee the survival of the world’s financial system.

And while free-market capitalists might find these measures disturbing, the alternative may have been economic fallout not seen since the 1930s. Fed Chairman Ben Bernanke has studied the Great Depression and the policy errors made in those days. And it is clear that regulators believe the best course is to act swiftly and forcefully to attack a financial crisis. Ideally, our government will act as a silent partner in these institutions and then exit the private economy as soon as it can.

Much of the relentless selling over that eight-day stretch can be attributed to certain investors’ deleveraging their portfolio. It is instructive to understand that leveraged investors were fleeing stocks not because they wanted to sell, but because they had to sell. Hedge funds and others who used borrowed money to boost their portfolios were receiving margin calls, and as their loans were called in, they had to sell stocks to pay them off.

Borrowing money to leverage up investment portfolios works wonders in bull markets, but it can put you out of business in a bear market. Just last year, Lehman Brothers earned $4 billion by investing $30 for every $1 it owned. Six months later, as the investments it owned sank in value, Lehman went bankrupt, unable to pay back the money it borrowed to juice its investment returns.

Also caught in the selling spiral were a number of high-profile CEOs who had borrowed money to acquire their company’s stock. The CEO of Chesapeake Energy, who has been an outspoken cheerleader of his firm’s long-term prospects, had accumulated a $2 billion stake in Chesapeake stock at its peak of $60 in July. The market plunge sent Chesapeake stock below $20, and triggered margin calls forcing him to sell his entire stake at prices as low as $15 per share. The point being, leveraged investors are forced out of stocks near their lows-the worst time to be selling stocks.

In the aftermath of all the various government “plans,” I am left with a single mental image burned into my consciousness of Hank Paulsen and Ben Bernanke: Neck veins straining, they’re ripping the kitchen sink from its foundation and throwing it on top of the shredded remains of our financial system.

While investors now may be reaching the conclusion that our financial system will survive, they are turning their attention to the next storm cloud on the horizon- the economy. How long and deep this recession will be is unknown, but the stock market is forecasting that it will be a rough one.