Chaos on Wall Street

By Allan Sloan, senior editor at large

(Fortune Magazine) -- What in the world is going on here? Why is Washington spending billions to bail out Wall Street titans while leaving struggling homeowners to fend for themselves? Why are the Federal Reserve and the Treasury acting as if they're afraid the world may come to an end, while the stock market seems much less concerned? And finally, what does all this mean to those of us who aren't financial professionals?

Okay, take a few breaths, pour yourself a beverage of your choice, and I'll tell you what's happening - and what I think is going to happen. Although I expect these problems will resolve themselves without a catastrophic meltdown, I'll also tell you why I'm more nervous about the world financial system now than I've ever been in my 40 years of covering business and markets.

Finally, I'll tell you why I fear that the Wall Street enablers of the biggest financial mess of my lifetime will escape with relatively light damage, leaving the rest of us - and our children and grandchildren - to pay for their misdeeds.

We're suffering the aftereffects of the collapse of a Tinker Bell financial market, one that depended heavily on borrowed money that has now vanished like pixie dust. Like Tink, the famous fairy from Peter Pan, this market could exist only as long as everyone agreed to believe in it.

So because it was convenient - and oh, so profitable! - players embraced fantasies like U.S. house prices never falling and cheap short-term money always being available. They created, bought, and sold, for huge profits, securities that almost no one understood. And they goosed their returns by borrowing vast amounts of money.

The fantasies began to fade last June when Bear Stearns (BSC, Fortune 500) let two of its hedge funds collapse because of mortgage-backed-securities problems. Debt market - both here and abroad - went sour big-time. That, in turn, became a huge drag on the U.S. economy, bringing on the current economic slowdown.

And before you ask: It's irrelevant whether or not we're in a recession, which National Bureau of Economic Research experts define as "a significant decline in economic activity spread across the economy, lasting more than a few months." What matters is that we're in a dangerous and messy situation that has produced an economic slowdown unlike those we're used to seeing.

How is this slowdown different from other slowdowns? Normally the economy goes bad first, creating financial problems. In this slowdown the markets are dragging down the economy - a crucial distinction, because markets are harder to fix than the economy.

A leading political economist, Allan Meltzer of Carnegie Mellon, calls it "an unusual situation, but not unprecedented." When was the last time it happened in the U.S.? "In 1929," he says. And it touched off the Great Depression.

No, Meltzer isn't saying that a Great Depression - 25% unemployment, social unrest, mass hunger, millions of people's savings wiped out in bank collapses - is upon us. Nor, for that matter, am I. But the precedent is unsettling, to say the least. You can only imagine how unsettling it is to Federal Reserve chairman Ben Bernanke, a former economics professor who made his academic bones writing about the Great Depression.

Academics now feel that the 1929 slowdown morphed into a Great Depression in large part because the Fed tightened credit rather than loosening it. With that precedent in mind, you can see why Bernanke's Fed is cutting rates rapidly and throwing everything but the kitchen sink at today's problems. (Bernanke will probably throw that in too, if the Fed's plumbers can unbolt it.) None of this Alan Greenspan (remember him?) quarter-point-at-a-time stuff for him.

So why hasn't the cure worked? The problem is that vital markets that most people never see - the constant borrowing and lending and trading among huge institutions - have been paralyzed by losses, fear, and uncertainty. And you can't get rid of losses, fear, and uncertainty by cutting rates.

Giant institutions are, to use the technical term, scared to death. They've had to come back time after time and report additional losses on their securities holdings after telling the market that they had cleaned everything up. It's whack-a-mole finance - the problems keep appearing in unexpected places. Since the Tink market began tanking, so many shoes have dropped that it looks like Imelda Marcos's closet.

We've had problems with mortgage-backed securities, collateralized debt obligations, collateralized loan obligations, financial insurers, structured investment vehicles, asset-backed commercial paper, auction rate securities, liquidity puts. By the time you read this, something else - my bet's on credit default swaps - may have become the disaster du jour.

To paraphrase what a top Fednik told me in a moment of candor last fall: You realize that you don't know what's in your own portfolio, so how can you know what's in the portfolio of people who want to borrow from you?

Combine that with the fact that big firms are short of capital because of their losses (some of which have to do with accounting rules I won't inflict on you today) and that they're afraid of not being able to borrow enough short-term money to fund their obligations, and you can see why credit has dried up.

The fear - a justifiable one - is that if one big financial firm fails, it will lead to cascading failures throughout the world. Big firms are so interlinked with one another and with other market players that the failure of one large counterparty, as they're called, can drag down counterparties all over the globe. And if the counterparties fail, it could drag down the counterparties' counterparties, and so on. Meltdown City.

In 1998 the Fed orchestrated a bailout of the Long-Term Capital Management hedge fund because it had $1.25 trillion in transactions with other institutions. These days that's almost small beer, because Wall Street has created a parallel banking system in which hedge funds, investment banks, and other essentially unregulated entities took over much of what regulated commercial banks used to do.

But there's a vital difference. Conventional banks have reason to take something of a long-term view: Mess up and you have no reputation, no bank, no job, no one talking to you at the country club.

In the parallel system a different ethos prevails. If you take big, even reckless, bets and win, you have a great year and you get a great bonus - or in the case of hedge funds, 20% of the profits. If you lose money the following year, you lose your investors' money rather than your own - and you don't have to give back last year's bonus. Heads, you win; tails, you lose someone else's money.

Bernanke and his point man on Wall Street, New York Fed president Tim Geithner, know everything I've said, of course. As does Treasury Secretary Hank Paulson, former head of Goldman Sachs (GS, Fortune 500).

They know a lot more too - such as which specific institutions are running out of the ability to borrow and have huge obligations they need to refinance day in and day out. Walk by Fed facilities in New York City or Washington, and you can feel the fear emanating from the building.

Because these aren't normal times, the Fed has tried to reassure the markets by inventing three new ways to inundate the financial system with staggering amounts of short-term money. This is in addition to the Fed's existing mechanisms, which are vast.