The Wall Street Journal Guide to The End of Wall Street as We Know It

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It goes without saying that risk is at the heart of a capitalist system. The worrying, the chin scratching, nail-biting and hair pulling that go with it are part and parcel of an economy organized around risk. You can take a calculated risk, a measured risk or an educated risk. But you can't eliminate risk from capitalism without turning it into a system more akin to socialism or communism. You can't have capitalism without some level of risk. And you can't have risk without some level of worry. In the current environment, sometimes the level of worry has exceeded logic. In early December, for instance, short-term Treasury notes actually traded with a negative yield. That meant investors were paying the government to lend it money, an exceedingly rare quirk that underscored the high degrees of fear and worry in the marketplace.

During the twenty years prior to our current financial crisis, concerns about risk steadily diminished. The recovery from the 1987 crash came so quickly that investors embraced the philosophy of "buying on the dips." The notion: stocks eventually recover, so buying on declines made eminent sense. This, however, is a fairly flabby notion. Not every drop recovers so quickly. Buyers of Japanese stocks during the "dip" of the early 1990s are still waiting for a recovery. The same goes for those who bought a number of Internet stocks after they fell from great heights to near oblivion.

In the 1990s, the savings-and-loan fiasco seemed enormous at first. Savings & Loans, sometimes known as thrifts, had lent large amounts of money to developers with grandiose real estate plans. When those plans failed, many savings-and-loan institutions failed, property developments went bust and the government had to step in with billions of dollars to rescue the S&Ls. But the problem seemed to fade away fairly quickly once the rescue got under way with the establishment of the Resolution Trust Corp. The RTC bought up the bad stuff and eventually resold it once the market recovered. In the end, the cost of the S&L crisis, in inflation-adjusted dollars, came out to a mere $256 billion-a pale echo of the trillions in bailout money already deployed in the current crisis.

In late 1997 came the Asian financial crisis. The contagion from that crisis led to huge losses around the globe and even forced the New York Stock Exchange to close trading early during one session-something that hasn't happened in the current crisis. But the crisis had few lasting effects. The Asian economies and markets recovered briskly, and the U.S. market resumed its Internet and technology stock mania. Again, it seemed that risky events resolved themselves rapidly. The fear of risk diminished by one more notch.

Many people lost money and businesses went under when the Internet and technology bubble burst. But the economy suffered little collateral damage. Even an event as devastating as the September 11, 2001, terrorist attacks did not have a permanent impact on markets. Manhattan real estate prices momentarily buckled, but by December of that same year, prices started shooting higher, even as the World Trade Center site smoldered.

For nearly two decades, it seemed as though nothing much could shake the confidence of global markets. Recessions were getting shorter and milder, expansions becoming longer. Developing giants such as China, India and Brazil fed global economic growth. A peso crisis, Russian and Argentine debt defaults, wars, famines and uprisings came and went as the markets and global economies steamrollered ahead.

As the 2000s began, confidence in the resiliency of the financial system couldn't have been higher and conversations with Wall Street professionals couldn't have been more surreal. In 2004, I asked the head of a major European bank about the widespread notion that his bank behaved more like a hedge fund, making large bets with both its own money and borrowed money, This risk-taking often centered on speculative market bets or investments in exotic financial instruments, often referred to as derivatives. "Aren't you concerned about taking on so much risk?" His response: "More risk is simply more profit."

A short time later, a Wall Street executive, when asked a similar question about how his firm felt comfortable using large amounts of its own capital to make risky market investments and fund acquisitions that required large amounts of debt, said, "We have learned to master the distribution and management of risk." Wall Street firms, including Morgan Stanley, Goldman Sachs and Bear Stearns insisted that they had "stress tested" their systems and figured out how to minimize exposure. They said they were prepared for the 100-year storm, should it come. Of course, this was just talk. Few people really expected such a storm to come. Indeed, as financial instruments became more complicated, the risk-management systems couldn't keep up with the transactions, thus undercutting the efficacy of the so-called system stress testing. The reported "value at risk," a measure of the danger Wall Street firms faced in crisis, gave a false sense of security and order to a marketplace increasingly based on frightening levels of risk.

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Excerpted from The Wall Street Journal Guide to the End of Wall Street as We Know It by Dave Kansas Copyright © 2009 by Dave Kansas. Excerpted by permission.
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