"These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it."

Thus sayeth Alan Greenspan in March 1999.

He was talking about the sophisticated financial instruments that have been in the news lately - derivatives. Another view of derivatives was expressed by someone who actually knew something - Warren E. Buffett, the sage of Omaha. He called them "weapons of mass destruction."

Who was right? Ask Bear Stearns' shareholders!

Last week was "hell week," for the poor people who owned the business. They went skiing or fishing on Friday evening. When they turned on the news Monday morning, they found that they had been wiped out. Bear's bridge-champion chief, Jimmy Cayne, for example, had more than a billion dollars' worth of Bear stock. But when the dust settled last week it was worth only $30 million.

What went wrong? The firm made a big bet - on derivatives, of course. Not that we feel sorry for Mr. Cayne. He should have known better than anyone what he had. And if he'd been smart, he would have gotten rid of it. Besides, the whole Bear team had it coming. When LongTerm Capital Management got into trouble 10 years ago, Bear refused to come to its aid.

And it's not as if he's going to be out on the street, begging for quarters. You can still live well with only $30 million.

Well, you can still live fairly well. The price of diesel fuel rose to $4.06 a gallon in the United States last week. So, maybe he should switch to gasoline. And if things get worse, maybe he could move in with his parents - the San Diego paper says that even middle-aged people are moving back in with Mom & Dad to cut expenses.

It's not just Bear shareholders who might be feeling pinched. All up and down Wall Street, the masters of the universe are getting their bonuses reduced…their stocks cut in half…and their stock options are expiring worthless. Last week, S&P downgraded Lehman (NYSE:LEH) and Goldman (NYSE:GS) to "negative."

Of course, this is just the sort of thing that happens when the credit cycle turns negative: the imaginary wealth created in the boom and bubble phases disappears. And that's why a credit contraction is so deflationary - people discover that they don't have as much money as they thought they had. Then, they have to cut back…

And contrary to the predictions you hear from Wall Street and Washington, the credit cycle doesn't turn around in a few months. The pundits who call for a "recovery in the second half" will probably be disappointed. If the peak of the credit cycle passed last year, the downturn could last for many years to come…

For proof, we turn our weary eyes across the vast Pacific, to the island nation of Japan, which has been in a slump ever since George Bush I threw up on its Prime Minister at a state dinner. And now comes word that, for the first time in five years, Japanese households have lost wealth. The Tokyo stock market seemed to be in recovery…then, whammo, it got hit hard again this year. [Japanese stocks are so despised, so unappreciated, and so cheap that they are a buy in our book. Not that we think they are going up…we just feel sorry for them.]

And now, all over the world, financial firms are checking to see what is on their balance sheets…and preparing Plan Bs.

"We come in every day at 3:30 a.m. and leave at 6 p.m. I'm not used to setting my alarm for 2:45 a.m., but these are extraordinary times," says Bill Gross of PIMCO, the largest bond fund in the world.

"Bear Stearns has made it obvious that things have gone too far," he continues. "The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system."

The New York Times explains:

"In the past decade, there has been an explosion in complex derivative instruments, such as collateralized debt obligations and credit default swaps, which were intended primarily to transfer risk.

"These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street's most outsized profit engines. They don't trade openly on public exchanges, and financial services firms disclose few details about them.

"Bear Stearns's vast portfolio of these instruments was among the main reasons for the bank's collapse, but derivatives are buried in the accounts of just about every Wall Street firm, as well as major commercial banks like Citigroup and JPMorgan Chase. What's more, these exotic investments have been exported all over the globe, causing losses in places as distant from Wall Street as a small Norwegian town north of the Arctic Circle."

Now, this new financial network is coming out of the shadows…and dropping dead in the middle of the street.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.