Maybe those who said that the Blackstone IPO would mark a top in the stock market were right. Such opinions seemed too easy, but here it is, priced at frothy levels and floating on air while the rest of the stock market seems tied to debt-laden loafers.

The bulletproof

Blackstone

(BX) - Get Report

deal soared quickly into the stratosphere Friday, despite opposition far from Wall Street: namely, Capitol Hill. The deal priced at $31 per share and ended its first day of trading up 13% at $35.06.

Simultaneously, investors sold off the rest of the stock market as they watched credit investors reconsider risk in the high-yield bond and leveraged loan markets, the very engines that fuel the huge profitability of Blackstone's core business -- leveraged buyouts.

"To the extent that there is a reduction in liquidity in the financial system, all markets can be hurt," says Martin Fridson, publisher of

Leverage World

.

Traders relied on buyouts and buyout rumors coming with high premiums to keep stocks at elevated levels over the past year. It wasn't hard to do the math. The buyout shops and corporations making takeover bids could finance their payments in the low-cost high-yield bond and leveraged loan markets.

Several events over the past week followed on the heels of a recent jump in interest rates to intensify investors' fears that the deal flow may dry up and pull that floor out from under the stock market.

Interest rates alone

wouldn't do it, says one hedge fund manager who declined to be named. "The stool has several legs," he says, noting three factors -- rates at 6%, risk repriced in the credit market, and higher global bond yields -- would be three legs of a stool that could impede liquidity. Though, he also notes that "all hedge fund managers are value managers at heart," and any contraction in credit markets would provide a nice opportunity to buy in.

This week, hedge fund blowups and the specter of future regulation and protectionism surrounding the Blackstone IPO, heaped atop widening credit spreads and troubled low-quality bond and loan deals, amounted to an ugly run for stocks and credit.

The

Dow Jones Industrial Average

fell 1.4% or 185 points Friday to close at 13,360.26, down 2% on the week. The

S&P 500

finished down 1.3% Friday to close at 1502.56, which is off 1.9% for the week, while the

Nasdaq Composite

finished down 1.1% Friday to close at 2588.96, which is down 1.4% on the week.

Any true signal of a credit-cycle turn could take months to truly determine, but "the stock market is in a trading range, due to all these issues," says Jim Herrick, head trader at Robert W. Baird. "I think it will be volatile."

For this week, the saga of two

Bear Stearns

( BSC) hedge funds that made a wrong-way bet in the subprime mortgage market dragged down investor sentiment in the shadow of Blackstone's IPO. The hedge funds' overleveraged bet and their lenders' reaction sparked fears of tighter standards among banks for leveraged investors, which could lead to less liquidity in the marketplace -- and less demand for deals.

As of late Friday, the Bear Stearns hedge funds had a friend in the form of the brokerage firm bearing their name. Bear Stearns agreed to provide the hedge funds a $3.2 billion loan to help the hedge funds, avoiding liquidation "fire sales" of assets collateralizing the hedge funds' loans.

While the damage for Bear Stearns and its hedge funds seems contained for now, investors once again focused on the subprime mortgage market and how bad things may get there.

And, many wondered if the troubles with Bear could lead to a ratcheting back of similar types of collateralized debt instruments, which have been huge buyers of the bond and loan deals that have financed leveraged buyouts.

Indeed, spreads, or risk premiums in the high-yield bond market, widened by about 14 basis points in the week, and by about 45 basis points in the derivatives market for high-yield bonds, according to Merrill Lynch. Also, a calendar of $15 billion of highly leveraged deals to finance LBOs trimmed to $13.5 billion as deals started to falter.

"There are signs of cracks," says Matt Fuller, analyst in Standard & Poor's Leveraged Commentary and Data unit, referring to the ability to finance leveraged buyouts. "The execution of the deals leading up to the July 4 weekend will set the tone for

deals to finance the leveraged buyouts of

First Data Corp.

(FDC) - Get Report

and

Alltel

(AT) - Get Report

later this summer."

In particular, the $1.5 billion deal to finance the buyout of

Ahold's

( AHO) U.S. Foodservice unit by Clayton Dubilier & Rice and Kohlberg Kravis & Roberts was cut to $1.1 billion, and investors pushed back on underwriters that were trying to price the deal at low yields with special provisions, according to S&P.

The same was true for the now $1.6 billion deal for Apax Partners' buyout of

Thomson's

( TOC) education unit. That deal was originally $2.14 billion. Similar issues are cropping up for next week's expected $1.9 billion deal to finance

Dollar General's

(DG) - Get Report

buyout by KKR as well, says S&P.

"This could really be quite a pickle," says Randy Diamond, trader at Miller Tabak, of faltering bond deals tied to highly leveraged buyouts. "The situation in the credit market should be of major concern."

The brokerage stocks fared poorly this week as a result of all the turmoil. The Amex Securities Broker Dealer Index slid 3.6% on the week as Bear Stearns dropped 4.1% and Merrill Lynch fell 6.1%.

With a Federal Open Market Committee meeting on tap for next Thursday, Congress may quiet down about private equity taxation, but the markets are unlikely to mellow until the holiday week that follows.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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