The 1987 sharemarket crash, the Asia crisis and the United States savings and loan crisis might yet all pale into insignificance compared with the fallout from the past fortnight's turmoil on Wall Street.
"To start with, one has to recognise that what we are witnessing is the deleveraging of the global financial system and, in turn, the deleveraging of the real economy," Bank of New Zealand research economist Stephen Toplis said.
"We had all become far too used to using debt to fund our lifestyles and saw little risk in borrowing as much as possible. This applied equally to the mum and dad speculator in the housing market as it did to the massive financial beasts that roamed the world."
Because it had not happened before, no-one had ever truly contemplated what might happen if one of the legs on which the system had evolved was removed. Now we know, he said.
So what did happen?
The subprime mortgage crisis in the United States was the first sign that all was not well with the global financial system. Subprime is Wall Street speak for junk.
Until 1933, home mortgages in the US generally had terms of three to five years, similar to New Zealand's fixed mortgage market used by 80% of home owners. US homeowners had to go back regularly to refinance their mortgages.
If a mortgage could not be refinanced because the homeowner was unemployed or because the price of the home had fallen too much relative to the home loan amount, a homeowner had to pay back all principal, typically a huge payment, or lose the house.
Congress created the Home Owners' Loan Corporation to force some fundamental shifts in mortgage institutions. The HOLC swapped its own debt, which was guaranteed by the government, for mortgages of defaulting homeowners and it reissued mortgages with some important new features.
The new loans had a 15-year term and were self-amortising - the homeowner made the same fixed payment each month until there was nothing more to pay.
The trouble began when competition among lenders resulted in very low "teaser" interest rates being offered to people who could not really afford a house.
When those low rates rolled off, many home owners found they could not pay the true rate of the mortgage which was substantially above what they had been paying. The problem was compounded when they found their houses were worth a lot less than their mortgages.
Many of them walked away from their homes, took the keys back to the bank, and defaulted on their mortgages.
Unfortunately, the lenders had sliced and diced the mortgages and resold them off to other lenders.
Imagine five loaves of sliced bread standing upright and think of them as towers of mortgages with the most secure at the top and the riskiest at the bottom. The top slices of each loaf were combined and sold off at a lower interest rate because they were the most secure. As the rest of the slices were sold off, the rate was higher because of the risk.
The first loans to fail were the bottom slices, but the rot spread upward as large lending institutions ran out of money. The sliced and diced loans were put into things called collateralised debt obligations (CDOs), complicated securities based on pools of other mortgages.
Consumers were given big mortgages with little documentation and sometimes no money down. When they began to default, large financial institutions in the US started feeling the heat.
Investors wanted their money out rather than putting it into financial institutions. Those institutions had lent long and borrowed short, putting them into a cash flow crisis.
Retail banks started to get nervous and stopped lending to each other, making the situation worse for those institutions. Once the first bank failed, others were doomed to follow.
Why should we in New Zealand worry about what is happening in the US? Because the cost of our mortgages stays higher than it should because it costs our banks more to borrow money off shore.
Some of those banks have, in turn, bought up some of the US mortgages and found they have millions of dollars of liabilities on their balance sheets for which they have had to account or write off.
The latest episode started when the US Treasury nationalised Fannie Mae and Freddie Mac (see panel) on September 8. They had combined assets of more than $US5 trillion ($NZ7.6 trillion). These firms helped guarantee most of the mortgages in the US.
Also that week, the largest bankruptcy filing in US history was made by Lehman Brothers. Lehman had more than $US600 million in assets and 25,000 employees.
The next day, the Federal Reserve made a bridge loan to AIG, the largest insurance company in the world and the shirt sponsor for Manchester United. AIG had more than $US1 trillion and more than 100,000 employees worldwide.
Lehman's demise came when it could not even keep borrowing. Lehman was rolling over at least $US100 billion a month to finance its investments in real estate, bonds, stocks and financial assets.
AIG had to raise money because it had written off $US57 million of insurance contracts whose payouts depended on the losses incurred on subprime real estate-related investments. The Fed decided that a default by AIG would wreak havoc on the financial system and cause contagious failures so it loaned it $US85 billion.
In New Zealand, we have all known about the risks that were developing but we were all too quick to go into denial.
Mr Toplis said the "mum and dad investors" were happy to supply money to financiers to lend to developers who would on sell properties to the same mums and dads all in the name of allegedly no risk, high return property deals.
The mum and dad investors, and the professionals involved in the process, were all able to take on greater and greater amounts of debt to fund other spending on the premise of ever increasing valuations on their property.
"Inevitably, this all got out of control and the whole process started unravelling. The problem being that there was much more debt out there than the now re-valued assets would support. Therein developed the hole that the global financial system is now falling into."
