Strange week ends strangely

This could be a headline drawn from The Onion, but as comical as it sounds, it more or less describes this past week on Wall Street, which saw wild 200- and 300-point swings in a matter of hours on the Dow Jones Industrial Index. For instance, on Friday the Dow hit its low point shortly before 11am. By 12:30pm, the Index had posted a 260-point rally.

One interpretation of the ongoing market volatility is that no one knows what the hell is going on. Where is the exposure to risk in the financial system? There is a lack of information and certainty regarding the exposure of financial institutions to various funds holding paper that has tanked in value, and while I suspect the true value of deteriorating junk bonds and subprime-related paper is quite small as a percentage of overall assets, they are considerable enough to be fairly large problems if one to two institutions have miscalculated their risk.

But those are credit-market problems…why have the equity markets gyrated so wildly in response to a rather localized event? The connective tissue between credit-market behavior and stock market value is hard to nail down, but in attempting to figure it out, start with the banks. One senses that the bankers themselves are somewhat at a loss for information and, perhaps, not sure what their own institutions’ exposure amounts to; therefore, not knowing the status of their current loans, they are loth to make new ones.

Over the course of Friday afternoon, the Fed’s announcement that it would provide liquidity to the credit markets seemed to operate as palliative of sorts, but given the befogged state of the marketplace, bankers and other actors—after years of applying too little caution—are now perhaps applying too much caution, thanks in part to the financial-news echo chamber of the past few weeks. As bad news bounces against walls, it doubles and triples back, and everything seems much worse than it is. For a few players, things are bad indeed, but I would expect (or hope) to see in the coming week something approaching normalcy in the credit markets, at least for investment-grade paper. Unless, of course, the banks are left holding more paper than we (and they) think.

So, if I were to posit a reason for the market volatility of late, I would chalk it up to a few large investors catching a case of the jitters from their bankers, and human beings, being what they are, then soon begin behaving as schools of fish do…the lead fish swerves and all the others follow suit.

At the end of the day, the trouble in the credit markets is not a forest fire, but it could be the lightning strike that gets the dry mulch burning. As with all things, we’ll have to wait and see.