The striking thing about the seemingly endless collapse of the subprime-mortgage market is how egalitarian it has been. It's nearly impossible to draw a demographic line between the victims and the perps. Millions of ordinary people ignorant of high finance have lost billions of dollars, but so have the biggest names on Wall Street, and both groups made exactly the same bet: that real estate values would never fall. Stan O'Neal, the former C.E.O. of Merrill Lynch, was fired for the same reason the lower-middle-class family in the suburban wasteland between Los Angeles and San Diego may have lost its surprisingly nice home. Both underestimated the likelihood of an unlikely event: a financial panic. In retrospect, the small army of Wall Street traders who lost tens of billions of dollars in subprime-mortgage investments looks as naive and foolish as the man on the street. But there's another way of viewing this crisis. The man on the street, for the first time, acted on the same foolish principles that have guided the behavior of sophisticated Wall Street traders for the past few decades.

If you had to pick a moment when those principles first appeared a bit shaky, you could do worse than the 1987 stock market crash. Black Monday was the first of a breed: a panic that suggested disastrous economic and social consequences but in the end had no serious effects at all. The bursting of the internet bubble, the Asian currency crisis, the Russian government bond default that triggered the failure of the hedge fund Long-Term Capital Management—all of these extreme events seemed, in the heat of the moment, to have the power to change the world as we know it. None of them, it turned out, was that big of a deal for the U.S. economy or for ordinary citizens. But the 1987 crash marked the beginning of something else too—a collapse brought about not by real or even perceived economic problems but by the new complexity of financial markets.

A new strategy known as portfolio insurance, invented by a pair of finance professors at the University of California at Berkeley, had been taken up in a big way by supposedly savvy investors. Portfolio insurance evolved from the most influential idea on Wall Street, an options-pricing model called Black-Scholes. The model is based on the assumption that a trader can suck all the risk out of the market by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how steep. Nearly every employee stock-ownership plan uses Black-Scholes as its guiding principle. A pension-fund manager sitting on billions of U.S. equities and fearful of a crash needn't call a Wall Street broker and buy a put option—an option to sell at a set price, limiting potential losses—on the S&P 500. Managers can create put options for themselves, cheaply, by shorting the S&P as it falls, and thus, in theory, be free of all market risk.