Anyone following the stock market cannot but feel that something is seriously out of joint. At this time last year the market was roaring ahead and the Dow (by some estimates) was headed for 16,000. Then the "subprime" problem showed up, eventually turning into a "credit crunch", which became a "crisis of confidence" now morphing  into a massive government bail-out of Wall Street. We have had several drops in the prime rate in quick succession, together with "injections of liquidity" in the hundreds of billions, to no apparent effect except to make matters worse. What is wrong?

Answer: the markets are worth less (a lot less) than the value currently assigned to them, and despite everyone's best efforts they are simply obeying the law of gravity.

Part of it is cyclical, meaning the recession now beginning after two decades of nearly uninterrupted growth. Such a long period of business prosperity always generates overconfidence as well as financial excess in various forms - excessive indebtedness being the most usual one. Normal business contractions flush the excesses out and restore the proper financial balance.

The other contributing factor (and this is where the real problem lies) is "systemic", that is, inherent in the structure of the financial system as it has evolved over these two decades. This is the issue of "valuation", of perceived versus real value. The last decades have seen a massive creation of perceived value, while real value has lagged far behind. The result has been a broad dilution of value, which is now, with the mortgage crisis as trigger, becoming widely recognized - or at least felt. Hence we are witnessing an accelerating downward slide of market indices, though the actual cause is still hidden beneath technical jargon and half-truths.

This real cause is the rise of "financial engineering" and of the "derivatives" market. Our grandfather's financial market dealt in two items: stocks (company shares) and bonds (certificates of company debt). In addition there were specialized markets for commodities (oil, metals, wheat, and the like) run by professional traders and a fringe of speculators. The common characteristic of the assets traded was that all were backed by real (tangible) collateral: the issuing firms' tangible assets (facilities, equipment, inventories, patents, etc) or actual stocks of a given commodity.

By contrast, derivatives are "financial assets" or "financial instruments" the value of which is not based on tangible collateral but on the value of other financial instruments. The value of the derivative is connected to this underlying asset either in terms of the perceived value of that asset or in terms of the change in that value. One can, for instance, "bet" that the Dow will go up (or down), that the price of oil will rise (or fall), or that a given company will do well (or go bankrupt). This vastly increases the amount of money that can be made (or lost).

The development of derivatives in ever more imaginative and complex forms has changed the structure of the market, giving it the form of an inverted pyramid: at the base is your grandfather's type of investment (stocks, bonds and commodity futures), the value of which can be determined objectively; above it are successively larger layers of derivatives, more and more tenuously connected to the objective value base as they stack higher above it. The more one rises in this (inverted) pyramid, the more value is determined by perception - not what an "asset" is actually worth, but what one believes it is could be. Taken as a whole, this entire financial edifice leads to a vast dilution of value.

The development of derivatives has vastly expanded Wall Street activity, together with the employment, salaries, fees and commissions associated with it. In the era of low rates and cheap money, when mountains of cash were looking for any opportunity to earn high returns, fortunes were made. But the mechanism works  in reverse as well: If the narrow base on which the inverted pyramid stands shrinks or cracks, the higher layers become unstable much more quickly, and perceptions of value rapidly shift from euphoria to panic. The panic effect is enhanced by the fact that, contrary to commodities, stocks and traditional bonds, the market for derivatives is neither regulated nor centrally supervised. Most transactions are private over-the-counter deals between individuals and financial entities. The beast has many heads but no single brain.

The fear inspired by the tottering financial pyramid goes a long way to explain the governing authorities' (Federal Treasury and Federal Reserve Bank) near obsession with "stabilizing the markets". But, as a French proverb states, fear is a bad counselor. So far their activities have, if anything, made matters worse. The solutions, the wrong and the right, will be reviewed in the next column.