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Right after I moved to California, I bought a sliver of the Vanguard Growth Index Fund for $33.66 a share and invested it for “the long haul” in a 401(k) rollover account. If stocks had returned their alleged 7 percent a year, shares of the fund should be trading for about $60 a share (compounded). Today, nine years and a couple weeks later, VIGRX closed at $23.20, well under half of what it “should” have earned and, most painfully for yours truly, 31 percent below what I paid for it.

I reshuffled after the tech stock crash and had a little bit of luck: after the worst week in Wall Street history, my fund balance in that 401(k) rollover is only down 19 percent — after nine years. In 2004 I launched a cautious, sensible plan to dollar-cost average that account back to health. The credit bubble that energized the most recent bull move got me back to even last fall; even after moving a third of my stake to cash last fall, I lost all the gains of four patient, sensible, diversified years in six weeks. I tried buying back into my stock funds when there was blood on the streets; in seven days the market dived another 20 percent (making half of it back on Monday, fortunately).

Of course it’s unfair to gripe about stocks’ returns after a panic sell-off of epic proportions. Everybody’s portfolio stinks at times like these; it’ll sweeten when the fear turns to greed, as it inevitably does.

What gripes me is that I never did anything greedy; I never bought individual stocks on margin, I never dived into options or futures or currencies, I stayed with sensible mutual funds from a sensible fund family. Buying and holding a single fund, as illustrated above, would have cost me a third of my stake; reshuffling cut my losses to a fifth.

I guess I should be grateful: I’ve lived through two market crashes in eight years and I’m still sitting on 80 cents on the dollar. Many have been wiped out.

Melissa and I call experiences like this “tuition”: the cost of learning how the world works. Over the years I’ve gotten richer in experience, but I’d like to be getting richer in the ol’ rollover account.

One thing I have figured out for absolute certain: The only way to make your account balance rise is to put more into it than you take out. Everything else is casino winnings.

The radio show “This American Life” profiles what’s happening on Wall Street with “Another Frightening Episode About the Economy.”

This is must listening for figuring out what’s behind the current stock market sell-off. It describes the workings of “credit default swaps,” which financiers used originally to insure their investments in corporate bonds and make sure they were covered in case the bonds ever defaulted.

Because corporations are highly motivated not to default on their bonds — their bond ratings determine whether they can borrow money to keep their doors open and the lights on — buying insurance against bond default seemed like taking out fire insurance on something that had no reasonable expectation of ever burning down. You know, risk-free.

It works like this: The bonds exist in a world of their own and anybody can buy CDS (credit default swap) as an insurance policy against these bonds never being repaid. In the regulated insurance business, the only person who can insure your house is you. Now imagine if it were possible for all your neighbors to buy fire insurance on your house as well: this is how the unregulated CDS market works.

Why on earth would your neighbors want to buy fire insurance on your house that allowed them to be paid the house’s value if it burned down? Well, say your next-door neighbor saw your toddler playing with fire in the backyard and all the sudden he knows there’s a firebug living on the premises and the fire risk is much higher than anybody else believes. He’d love to go to your insurance agent and say “I’ll pay you a thousand bucks right now if you write me a fire insurance policy so I get paid if the house burns down.”

Your insurance agent knows nothing about the firebug toddler and figures this is the easiest thousand bucks he’ll ever make. It’s so easy that he might sell the premium to somebody else down the line and pocket a commission, or just to make sure he doesn’t get burned, he buys an insurance policy from another agent agreeing to pay him if your house burns down.

This set-up would work fine — all your neighbors and their insurance agents could take out policies on the homes in your neighborhood based on their perceptions of how likely it is that your house will burn down. But imagine what happens if your home actually burns down: now all these insurance agents who’ve taken their easy thousand bucks owe all the neighbors the full value of your home. (Won’t your neighbors cash in big time? Not necessarily: they were buying and selling policies on other homes and now that a house has actually burned, nobody know what those investments are worth anymore).

Remember when Lehman Brothers, the giant investment bank, failed a few weeks back? Well, its bonds were insured by something like $400 billion worth of credit default swaps. When Lehman went bankrupt, its bonds went into default. And now, all the big banks on Wall Street and a bunch of big hedge funds are on the hook for most of that $400 billion, and that’s why they’re not lending to anybody: they’re hoarding cash because they own CDS contracts obliging them to pay anybody who bought insurance on Lehman bonds. An auction will be set up later this week to figure out who gets paid.

Later this month, another auction will settle CDS contracts on Washington Mutual’s defaulted bonds.

How did all these Wall Street wizards get themselves into this jam? Well, they wanted to hedge their risk: if they had one CDS contract requiring them to pay a million dollars if a bond defaulted, they made sure they had another CDS contract paying them the same amount if a default happened. All the Wall Street CDS players traded these CDS contracts back and forth and earned a profit or booked a loss depending on what the market thought the CDS contracts were worth.

Everybody partied like mad till the unthinkable happened: actual defaults on actual bonds. Then it was game over because all these CDS contracts were connected in a chain no stronger than its weakest link. A small number of defaults set off a chain reaction that is spreading havoc on Wall Street as people confront the obligations they’ve taken on in these CDS contracts. If you owe billions you don’t have — and can’t raise — you are insolvent.

It’s going to be a messy few months while all this gets sorted out. Hopefully there won’t be any more massive bank failures to pour gasoline on the blaze before the Fed throws enough money at the financial system to put the fire out.

We’re just about done with one of most hair-raising weeks in Wall Street history. Last night, Melissa and I joked darkly that if the House of Representatives fails to pass the credit-crisis rescue plan, something far, far worse than “black” Friday would emerge. More like: Void Friday, or Black Hole that Sucks Up Everything Friday. Fittingly, the Dow Jones Industrial Average nose-dived immediately after the Successful Vote to Prevent Financial Catastrophe.  Could be they suspect the cure will be worse than the disease — and they would know, because it’s their disease. 

The saying goes that the United States of America can be trusted to do the right thing only after all other options have been attempted. Given that the proposed bailout went from three pages and a $700 billion blank check to 400-plus pages of Congressional wish fulfillment, I’m guessing we’re still in “other options” territory. 

At a doctor’s appointment the other day, Melissa found herself explaining to the doc what the crisis is all about. The doctor said she talked to CEOs, economics professors and all sorts of educated types who were simply flummoxed on what the hell’s going on — this within a mile of Stanford University, Big Brain Central of the Bay Area. 

Melissa used to work in banking, where Doing Things Smart was carved into the industry’s granite columns and pounded into the heads of the little people who did all the grunt work. She has a hard time believing what happened, happened. People with no credit history granted mortgages on homes they could not afford. Financial wiz kids packaging these junk loans into A-graded “collateralized debt obligations” and selling them to greater fools the world over. Investment banks going under when their risky bets with borrowed money went south.

The keys to understanding what the hell’s going on are leverage and liquidity. I’ll start with leverage:

Everybody with a mortgage is already using leverage and not even realizing it: exploiting the advantages of investing with borrowed money. Say you want to buy a house that cost $200,000. Even if you had 200k lying around you wouldn’t want that much cash tied up in a single investment, so you’d take out a mortgage and put up only a small stake of your own cash: the down payment. If you put $20,000 down and sell the house later at a $20,000 profit, you’ve made a 100 percent profit on your 20k investment. If you put up your whole 200k and earn 20k, it’s only a 10 percent profit. You don’t need an MBA to see which is the smarter way to a) invest 20k and b) protect the other 180k from market risk.

Buying a 200k house on 20k is a 10-to-1 leverage ratio. Big-money investors have found that with clever computer models they can take on extravagant leverage ratios like 30-to-1 and enjoy extravagant profits by buying and selling intricate investment vehicles most commonly called derivatives. As long as they properly assessed the risks against their bets going south, they could rake in the cash. The great thing about massive leverage is how a small amount of your own money can reap a small fortune; the bad thing is that when you bet wrong, you lose money at a 30-to-1 clip and here’s the catch: even if you decide to sell to get out from under these bad bets, there are no buyers — this is where liquidity comes in.

Liquidity merely represents how easy it is to turn an asset into cash. You’ll never have any trouble cashing in your GE stock because millions of its shares trade every day. The big investment banks, meanwhile, had all these highly leveraged bets tied up in obscure financial assets with a very small pool of prospective buyers and sellers. When their bets on these assets started losing money, they couldn’t sell them even if they wanted to: there simply weren’t any buyers.

The federal rescue plan creates a buyer for these securities so financial firms can get them off their books. The securities — tied to home loans, bonds and other kinds of debt that have intrinsic value — can’t sell right now because the financial firms are in a panic spiral: they need free cash to stay alive, but selling off these assets at fire-sale prices obliges them to book huge losses that force them to put up even more cash.

The only way out of the panic spiral is to create a separate market for these securities. They’re worth plenty most of the time (bonds, loans and other stuff folks are highly motivated to pay off); right now everybody’s so focused on keeping the lights on that they can’t or won’t take on the risk. But there’s a decent chance that the feds can buy these securities cheap and sell at a tidy profit down the road.

So that’s a kinda/sorta explanation of what got us to this point. I’m hopeful because all previous predictions of the apocalypse have proved premature.