Are we headed for an epic bear market?

Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.

The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door -- a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.

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So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.

In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.

Turning $1 into $20

The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.

These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.

According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.

When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.

Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.

A painful unwinding

Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.

Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.

One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle. In this context, banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Continued: 'Correction' may be an understatement

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