03/28/2008 02:48 am ET | Updated May 25, 2011

Anatomy Of A Panic

The global financial markets have just begun to recover from a financial panic that has driven some 43 stock markets around the world down over 20 percent a piece from their most recent all-time highs. In the parlance of the financial world, that means that there are 43 "bear markets" in stocks occurring simultaneously around the planet, including a bear market that's mauling Wall Street.

The financial market pressure was so intense over the last 48 hours that the Federal Reserve, our nation's famous central bank, took the nearly unprecedented step of slashing short-term interest rates by three-quarters of a percent, the largest single one-day cut in over 20 years, with a promise of more rate cuts to come ... possibly as early as next week.

Equally dramatic and surprising is that the cut came just 10 days before the Fed was scheduled to meet in Washington, where and when it was expected to make those cuts anyway.

The plunge in the global markets reflected a very real and palpable fear that our real estate recession and associated "credit crunch" will drive us into a deep and lasting recession, if one hasn't started already.

The story of the financial crisis we are witnessing is mind-numbingly complex, if told in the words of Wall Street. The global credit crisis, that erupted from the collapse of the U.S. sub-prime mortgage market, takes an extraordinarily circuitous route from Main Street to Wall Street and back again, and then on to the rest of the world's financial markets. Unlike the virtuous circle of prosperity that we have seemed to enjoy, the world over, in the last seven years, it appears that a vicious cycle of calamity be unfolding before our very eyes.

It began with the bursting of the bubble in residential real estate here in the United States. It quickly spread to other hot real estate markets around the world. Complex debt instruments that were linked to sub-prime mortgages, both here and abroad, imploded in value. The credit collapse spread by waves of delinquencies, defaults and foreclosures in sub-prime real estate, caused a contagion effect in other highly complex credit derivatives that were sold by Wall Street as safe bets to presumably savvy institutional investors around the world.

If your eyes are glazing over, it is entirely understandable. Many of the financial engineers who created these highly complex, and highly levered, investments didn't fully understand how the structures would behave, themselves, particularly when stressed in unanticipated ways.

But that never stopped them from creating more and more financial products with complicated names like "Collateralized Debt Obligations," (CDOs), or "Credit Default Swaps," (CDS) or "Asset-Backed Commercial Paper Programs," (ABCPP), that were built around highly risky sub-prime mortgage securities or other flaky investments, and then leveraging them to the hilt.

By the way, there is no more dangerous or incendiary combination on Wall Street than taking newly engineered financial instruments and using loads of borrowed money to boost their returns. These highly leveraged bets make investors tons of money when times are good. But, when times go bad, it's look out below!

Billionaire investor, Warren Buffet, very famously referred to these derivative products as "financial weapons of mass destruction." As always, the "Oracle of Omaha" was right. Unlike our experience in Iraq, we found our WMDs on Wall Street, or more accurately, they found us, with potentially grave consequences for the global economy.

There are some $750 trillion worth of credit derivatives trading on global markets. That compares, rather unfavorably, to the $50 trillion of global economic output, or GDP. As we enter a phase where these financial WMD's implode in value, they imperil the health of the global financial system and threaten to bring, not only our economic activity, but the vibrancy of the world's economy to a crashing halt.

Hence, the Federal Reserve, which has come very late to the rescue, slashed interest rates by a record amount on Tuesday. The Fed, and other central banks around the world, however, need to do much, much more to create an environment of calm and eliminate the possibility of further catastrophic "WMD" events, some of which may be getting ready to explode as I write.

The Fed let far too much time pass watching this crisis unfold over the last 11 months. The Fed fiddled while our homes burned. They can still put out the fire, but they need to use every tool at their disposal and get their counterparts around the world to do the same.

While their efforts to stave off crisis Tuesday were virtually unprecedented, they were not unwanted nor unwarranted. We can only hope they will finish the job they started so sheepishly, so those sheep who, in great herds, bought overvalued homes and followed the markets blindly over the last several years, won't be led to the slaughter.