Raise the Hammer

"if there is a shadow banking system, it is not a long stretch to assume that there is a shadow government as well"

Careful not to mix your metaphors. It's called a "shadow" banking system because it's an industry that does banking (take deposits and invest them -- sounds like a bank to me) but works outside the scope of banking rules.

Not because their existence is some kind of secret.

The issue here is derivatives. Most everyone assumed that hedge funds were failure-proof, since they used such a complex mix of long and short positions tracked by sophisticated algorithms written by Math Ph.D. Brainiacs and tweaked in realtime to maximize returns and mitigate risk across a variety of markets. And man did they maximize returns, the hedge funds outperformed nearly everyone else.

At least until Long Term Capital Management blew up, it was just assumed that hedge funds didn't have to be regulated because they hedged their own bets so efficiently (hence the name). Even after LTCM, lots of real smart people convinced themselves that it was a freaky one-off, no way it could happen again.

So they were unregulated, they paid crazy returns and seemed failsafe. As a result they grew super-massive, eventually growing even bigger than the banks.

They took aggressive long and short positions across global markets, playing havoc with currencies and flicking two-bit central banks away like unwanted boogies. They also got hot and heavy into subprime CDOs, which amazingly had AAA ratings from credit agencies because they were first on the creditor list in the event of default.

Banks were all chuckled to give mortgages to bad credit risks because they knew they could bundle them into securities and sell them off so that the hedge funds assumed the risk. The funds were happy to buy them because they thought they had an ace in the hole.

What they didn't count on was that the subprime industry would come down so fast and so hard. So many people defaulted that even the front-line creditors weren't getting paid. Because they were so leveraged (invest a little of your own, borrow the rest and pay the interest on the loan from the ROI) and they were way over their heads in hock.

The market panicked and people started trying to pull out their money -- just EXACTLY like an old-fahioned bank run. Yippe kaiay mofos, it's the wild west again. Hedge funds with half a trillion dollars in assets suddenly had crowds of investor banging on the door demanding their money (so to speak, since hedge funds don't have branches) and they had NO money to pay anyone.

They also had no money to invest anywhere. Turns out a big ole chunk of the economy was running on money invested from these funds, so when they imploded companies couldn't get their hands on capital (that's the "credit crunch" you keep hearing about).

A lot of banks were still solvent and lending money (especially in Canada, where banks weren't allowed to go to the party, boo hoo for them), but they're old-fashioned and conservative about who they give their money to, and a lot of the economy was running on loosey-goosey unregulated fund money.

Now we have a global economy with half the financial system killed off, terrified investors who won't lend, terrified consumers who won't spend, and rock bottom interest rates that you can't cut any more.

In other words, we're so screwed.