On yesterday’s blog, I talked about the challenges facing the US Federal Reserve. Using a jugglers metaphor, I talked about the potential problems associated with having so many balls in the air. A day later, it is clear that is not just the number of balls, but the speed at which the balls can drop. Dam gravity!

On Tuesday, the CEO of Bear Stearns goes on national television (CNBC) and states, for the record, that the company has sufficient liquidity. Two days later, Bear Stearns approaches its clearing banker JPMorgan Chase, and requests it to seek capital from the Fed discount window.

This quickly becomes public information. For one, JPMorgan Chase wants to make certain that everyone knows they were not seeking the capital for internal purposes. But were in fact seeking the capital on behalf of a client… Bear Stearns. In the financial business, perception is reality.

Some points of clarification are in order. Some might ask, why would Bear Stearns take this step, when as a primary dealer, it would have access to the $200 billion swap announced by the Fed earlier in the week. The reason? The swap was not available until the 27th of March. Clearly Bear Stearns could not wait.

So why then, did Bear Stearns go hat in hand to JPMorgan Chase? Why not simply talk to the Fed on its own. The reason? Bear Stearns is not a bank, it did not have access to the Fed’s discount window. JPMorgan Chase, Bear Stearns clearing bank, does.

So much for the background. What is clear is that the real problem is liquidity. Even for AAA-rated commercial paper, there is no readily available secondary market. It is not a question about credit quality. If you are in a position to hold the paper, you will get earn the regular interest payments, and will get your money back when it matures. The problem is that many players are not in a position to hold until maturity.

Think about it this way. Suppose a giant hedge fund leveraged at say 32 to 1 gets a margin call on its portfolio. It is holding AAA debt and it has priced the debt on its books at par.

The margin call requires the hedge fund to come up with capital or the primary broker will sell the assets at whatever price it can get. The hedge fund is not able to meet the margin call, and has to sell assets at whatever price it can get. Let’s say it sells at 95 cents on the dollar.

That becomes the new price for the paper. Now other financial institutions like say Bear Stearns, has to re-price the same paper which it also holds in its balance sheet at 95 cents on the dollar. It now has to sell before the 27th of March so that it can stay in business and continue to act as a counter party to other financial institutions. The counterparty business being, well, its primary business.

That causes another re-pricing and the cycle begins again. Do this enough times and the house of cards collapses.

Under this scenario, interest rate cuts will not by itself, solve the problem. Leveraged hedge funds cannot maintain their position whether they are borrowing margin at 3% interest or 1% interest. It will still get a margin call and it will still have to answer the margin call.

The Fed was obviously trying to short circuit these problems by offering to swap liquid treasuries for AAA commercial paper. Just not in time to save Bear Stearns. Which speaks to the speed at which these problems surface.

On the positive side, the Fed was willing to step in and save Bear Stearns. That implies for the moment, that it is not willing to allow Bear Stearns to fail. Even though, that is what will most likely happen in the weeks, and perhaps, days ahead.

You also must understand that blood in the streets, creates opportunity. Especially for investors with cash on the side lines willing to judiciously, step up to the plate and buy when everyone around you is selling.

For option traders, the opportunity comes in the form of higher premiums. Which is to say, this may be an opportunity to write puts on stocks that you would be willing to hold. Writing out-of-the-money puts on some of the Canadian banks which are not as deeply involved in this problem, may prove to have been a very attractive strategy. Names like Royal Bank, Toronto Dominion and Bank of Nova Scotia in the financial area.

It may also be time to look at writing covered calls or using bear call spreads on some of the oil companies. These companies are vulnerable if the US dollar strengthens. A stronger US dollar will drive oil prices lower.

But that will happen, if and only if, the Fed is able to convince the European central banks to cuts rates in concert with the Fed. My view is based on the position that the Fed is able to make that case.