No one creates a system-wide strategic disaster plan. Everyone forgot the lessons of how portfolio insurance magnified the losses suffered on Black Monday, October 19, 1987.

In the 1980s, everyone who handled money took out what was called “portfolio insurance.” It was software designed to track your investment portfolio. If the market value of one dropped by a certain percentage, the software would start selling it to stop the loss.

For a fund, for a falling stock, this is a good idea. Cut your losses early.

But when all the funds have this same plan, it means that when the whole market starts going down, everybody starts selling. So the market kept going down.

Therefore, the software kept issuing more sell orders.

Forcing the market further down.

The Dow fell 22% in one day, and automated portfolio insurance was responsible for much of the selling.

If you are in a theater and a fire breaks out, you know to run to the nearest exit. What will you do if hundreds of people block your way? Nobody on Wall Street thinks about it.

Something similar happened with Mortgage-Backed Securities (MBS), Collateralized Mortgage Obligations (CMOs), Collateralized Debt Obligations (CDOs), and Structured Investment Vehicles (SIVs).

They were sold to investors and institutions around the world as a surefire way to increase return on investment.

In this case, the problem was not due to the massive sale, because these securities are not liquid.

However, their yields began to fall as a large number of homeowners in the United States began to default on their mortgages and ended up in foreclosure.

Never before has anyone seen so many American homeowners default on their mortgage debt, but never before have so many unqualified people been allowed to buy homes despite little or no down payments, unverified income, and poor credit scores. .

Once the situation began to escalate, institutions holding MBS bonds saw their selling prices fall. Mark to Market rules (enacted in the aftermath of the 1980s savings and loan crisis) in the US forced them to reduce their balances at the end of each day.

Only JPMorgan Chase saw the danger. They began liquidating their portfolio of mortgage-related securities in October 2006.

Banks, hedge funds and other financial institutions around the world had been buying the MBS. If they didn’t own some, they probably owned shares in US banks that did. Or they had made loans to banks that did.

In addition, the world’s financial institutions and markets are interconnected through unofficial derivatives. Most of them are highly complex financial contracts designed to “manage” risk.

But remember, these people think that “risk” means “price fluctuation” and not “danger”.

Therefore, they take out derivatives that arrange their finances to make a profit in almost all financial conditions.

I stress “almost everything” because it is impossible to remove “all” danger from this world we live in.

Therefore, there is always a “highly unlikely” scenario that, if it happens, will make the derivative unprofitable.

These scenarios don’t happen often, but when they do, they cause enormous financial pain.

Derivatives are the financial equivalent of playing Russian roulette with a single bullet pistol and 99 empty (ie safe) chambers. The odds are very much in your favor, but if the only bullet is in the chamber when you pull the trigger, you’ll die anyway.

On Wall Street, the damage from the crisis was dramatic. Not so long ago, Wall Street had five investment banks that were like gods to the financial markets.

Now, Wall Street has zero investment banks!

In March 2008, two of Bear Stearns’ hedge funds went bankrupt and were bought by JPMorgan Chase.

In September 2008 Lehman Brothers was forced to declare bankruptcy.

However, also in September 2008, Goldman Sachs and Morgan Stanley were allowed to become bank holding companies. And they convinced Bank of America to buy Merrill Lynch.

And Americans and many taxpayers around the world are being forced to feel the pain along with the financial analysts or engineers who arrogantly thought they had conquered risk.