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Black and Scholes, with Merton’s help, came up with their option-pricing formula by constructing a hypothetical portfolio in which a change of price in a stock was canceled by an offsetting change in the value of options on the stock—a strategy called hedging. Here is a simplified example: A put option would give the owner the right to sell a share of a stock in three months if the stock price is at or below $100. The value of the option might increase by 50 cents when the stock goes down $1 (because the condition under which the option can be used has grown more likely) and decrease by 50 cents when the stock goes up by $1.

To hedge against risks in changes in share price, the investor can buy two options for every share he or she owns; the profit then will counter the loss. Hedging creates a risk-free portfolio, one whose return is the same as that of a treasury bill. As the share price changes over time, the investor must alter the composition of the portfolio—the ratio of the number of shares of stocks to the number of options—to ensure that the holdings remain without risk.

The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.

But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down.

(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.

I was not expecting (2) plus:

(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had held on to much too much of the risks that they were supposed to find other people to handle.

(6) the panic flight from all risky assets--not just mortgages--upon the discovery of the problems in the mortgage market.

(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.

(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.

(9) the Bush administration's sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.