In an attempt to short-circuit a recession, the U.S. Federal Reserve Board is applying first aid to the financial system. But with each intervention, the concept of diminishing returns hits closer to home.

We saw evidence of that on March 11 and March 18, when the Dow Jones industrial average rallied by more than 400 points. Traders first reacted to a swap-based intervention on March 11 with a 400-point upward spike in the Dow. In this case, the Fed offered to swap high-quality Treasury securities for “high-quality” mortgage-backed securities. The latter had no secondary market, making it clear that the swap was intended to provide liquidity to the financial system.

One week later, it also became clear that New York-based investment bank Bear Stearns & Co. Inc. would not survive long enough for the swap technique to help. Instead, over that weekend, a shotgun wedding was arranged — with the Fed holding the shotgun for the groom, J.P. Morgan Chase & Co. Inc.

At the same time, the Fed announced another liquidity infusion. This time, it opened the discount window for investment banks, a helping hand that in the past had been reserved exclusively for U.S. chartered banks. And the market again rallied by 400 points.

These rallies have been followed by equally dramatic downturns, leaving the market where it started and analysts watching intently to see if the Fed can maintain its campaign of extraordinary measures.

There is no question that, at this stage, liquidity is Job 1. And I am not talking about subprime mortgage debt. This is not about credit quality. This is about investment-grade commercial paper with no readily available secondary market. If you are in a position to hold the paper, you will earn the regular interest payments and receive your money back at some point. 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 24 to one, gets a margin call on its portfolio. It is holding investment-grade debt, priced on its books at par. The margin call requires the hedge fund to come up with capital; otherwise, 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, say, 95¢ on the dollar.

That sale transaction becomes the new price for the paper. Now, other financial institutions have to re-price the same paper held on their books in inventory at the new price. That causes another repricing, and the cycle begins again.

The issue for the Fed is that rate cuts don’t solve this problem. A leveraged hedge fund cannot maintain its position, whether it borrows at 3% interest or 1% interest.

Options traders know all about leverage. And they also understand that as long as so many balls are in the air, volatility will remain high. And there will be ongoing spikes in volatility if it appears that the Fed is about to drop one of those balls.

The Fed is hoping that the enhanced liquidity will inspire confidence, which will in turn persuade lending institutions to extend credit to creditworthy borrowers. So far, the results are mixed.

Take the leveraged buyout of Texas-based Clear Channel Communications Inc. by a group of private-equity investors. The bank consortium that agreed to finance this US$19.5-billion buyout did not show up for a March 28 meeting between the company and the buyers, even though a judge had issued a court order barring the banks from “hindering or undermining the deal.” This is an example of a creditworthy borrower dealing with a group of lenders that are having second thoughts.

This example also hits close to home, because some of the same institutions in that transaction are involved in the deal to buy BCE Inc.

For options 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 that are not as deeply involved in this problem may prove to be a very attractive strategy.

@page_break@You may also look at writing covered calls or using bear call spreads on some of the oil companies. These firms are vulnerable if the U.S. dollar strengthens because a stronger greenback will drive oil prices lower. And unless the Fed can keep the US$ from collapsing, all those balls currently in the air will be outweighed to the biggest ball of all — inflation.

Speculative traders could also look at options-writing strategies on the stocks in the eye of the storm: Clear Channel, J.P. Morgan or even BCE. IE