Crashes have many fathers, all named in hindsight. Twenty years ago this month, the stock market lost nearly a quarter of its value on a day known as Black Monday, and we’re still trying to figure out precisely what set it off.

Today’s world has spooky similarities to that of October 1987. The dollar is weak. A leveraged-buyout frenzy has just ended. American politicians fret about a rising Asian competitor (Japan then, China now) while a scandal-plagued Republican president slinks out of his final term.

And most important, we are now, like then, in the midst of fallout from an explosion of hedging strategies that gave rise to overconfidence. In other words, we are where the markets were in the fall of 1987. Then, the crash was deep, but its aftermath was fleeting. This time we’re in for something worse: a slow-moving, grinding bear market.

Think of the current situation as a deep-sea earthquake. The plates shifted late last year when home prices in the U.S. stopped rising. At the epicenter were borrowers with poor credit who had rushed to buy homes as interest rates hit lows not seen in decades. They flocked in particular to mortgages with low teaser rates that reset every two years. The extent to which these folks were vulnerable merely to a flat housing market was underappreciated by the home buyers, lenders, regulators, central bankers, Wall Street banks that packaged the loans for resale, and credit-ratings agencies that slapped faulty Good Housekeeping Seals on the newly created securities.

That minor shock unleashed a wave, and the structures situated most prominently on the coast were wiped out first: Dozens of subprime mortgage lenders, including Ameriquest and New Century, collapsed, laying off thousands. Two Bear Stearns hedge funds invested mostly in subprime securities said goodbye as default rates went up. The damage spread to surprising corners of global finance, to money-market funds at BNP Paribas—a French banking giant—and to IKB, a German bank whose primary business is lending to midsize industrial firms.

From now into the next year, the water will continue to rise regardless of what happens to the markets on any given day. Mortgages taken out by subprime as well as other “better” borrowers are likely to continue to go bad as housing prices keep falling. As that happens, banks that invested in securities linked to the subprime market will get hit, prompting them to rein in lending in other areas.

Companies unrelated to the mortgage market will find credit tighter as banks divert cash to cover their bets. Trades and investment strategies that relied on the cheap-money boom will unwind. Private equity firms that overpaid for companies will be stuck managing their new toys rather than flipping them, since their lenders won’t be willing to refinance to trim their debt. Big banks will be forced to reckon with bad loans. The financial markets will most likely be more volatile.

That may be good news for distressed-debt investors, but for few others. The number of deals will decrease, deeply denting the big investment banks’ profitability. They, in turn, will have to more carefully assess the creditworthiness of their partners and be more circumspect when investing in newfangled securities. Consumers, seeing their neighbors underwater from home-loan debt, will pull back their already tightening spending even more.

Though analysts have been warning about a mortgage-related shock for months, the contours of the coming decline are nonetheless bracing. Trouble started by America’s least affluent—a group that rarely sets our economic course—has begun to grow and spread, slowly affecting every corner of the financial world. Cleaning up the mess will take months, if not longer, and investors who thrived on the cheap credit and private-money deals that have defined this financial era may take years to recover.

While it’s not clear what caused the decline in 1987, we do know what exacerbated it. The in-vogue product that year was portfolio insurance: People who owned stocks sold futures contracts tied to the Standard & Poor’s 500-stock index as a hedge. If shares fell, the futures would rise in value, cushioning investors’ losses. The hedge was “dynamic,” automatically updated by computer-driven models.

The strategy was sound, provided only a few used it at once. But by midsummer 1987, portfolio insurance had become as ubiquitous as hair-metal music. Many people, driven by the same computer models, were placing almost identical bets. Rob Arnott, a well-known value investor who, in 1986, wrote a seminal article for Pensions & Investment Age that warned against the technique, says the amount of money invested with the strategy hit about $90 billion, or as much as 10 percent of all pension assets, that year. By comparison, the value of volume traded daily on the stock market was about $4 billion.

On the morning of Monday, October 19, after several rocky weeks, money managers using portfolio insurance came into the office needing to sell stocks. Because everyone was moving in the same direction, the New York Stock Exchange’s clunky trading system locked up. As stocks fell, more futures needed to be sold, pushing the stock market down and creating a ­vicious cycle. Mix in a dash of panic, and a strategy intended to be anodyne ended up causing searing pain.

Old Wall Street guys love talking about the 1987 crash—from this distance. Jeremy Grantham, chairman of the Boston money-management firm GMO, describes the period as “the most exciting days of my professional life.” Grantham, a value-investing icon and noted bear, told me he was in an investment meeting the Friday before the crash, urging a college endowment to hedge against a potential drop in the market and to do so right away. For technical reasons, the hedge was never put in place, and the crash hit the endowment much harder for the lack of it.

By the standards of today’s credit-default-swap and collateralized-debt-obligation-filled marketplace, portfolio insurance was almost laughably crude. Unlike current complex investment strategies, portfolio insurance, which was limited to stocks, was unusually concentrated. Investors now are “less focused on a single type of strategy that trades in a specific way,” says Arnott. But the lessons of that debacle remain pertinent. “While the kind of portfolio insurance practiced in 1987 is extinct, today there is portfolio insurance in disguise,” he says.

Now investors in the bond market use a different insurance strategy, called credit-default swaps, that employs instruments untested by crisis to protect bondholders against loan-repayment problems. The C.D.S. market, which had a $28 trillion value by the end of last year, provides useful protection and risk-spreading for investors—provided the seller can make the C.D.S. payment in case of default.

Similarly, defensive strategies devised by banks and hedge funds have also backfired in recent months, showing how even the most ingeniously complicated Wall Street concoctions can turn on their users. Banks sought to hedge their potential exposure to bad loans by betting against the LCDX, a recently created index that falls when fear of loan defaults rises. At the same time, hedge funds and investment banks sought protection through another recently created index, the ABX, which serves as a proxy for subprime mortgages.

Then an odd thing happened: Both of these insurance tactics unexpectedly crumbled. As investors and banks used these indexes to hedge, the selling put downward pressure on them. Since the underlying securities don’t trade much, the indexes serve as a benchmark for pricing them. Seeing these instruments fall, creditors demanded more collateral from those holding the securities. That led to selling, as the holders had to unwind positions to come up with the collateral. In other words, it was a repeat of 1987: The hedging instruments brought about the very thing they were supposed to prevent. “The very act of people acting in the market changes the nature of the market,” says Wall Street veteran Richard Bookstaber, author of A Demon of Our Own Design, an I-was-there study of recent financial calamities.

This summer, as in the fall of 1987, crowding in one specific strategy hurt investors. Quantitative hedge funds, which use sophisticated algorithms to make huge numbers of rapid-fire market bets, found that they had picked out precisely the same securities to buy and sell short (bet that they would fall). When quant funds’ holdings started falling, buyers were forced to reduce their exposure by selling more of the stocks they owned and buying more of the stocks they shorted.

Some of the most precious creations of Wall Street’s beautiful minds—Renaissance’s James Simons, Goldman Sachs’ Mark Carhart and Raymond Iwanowski of its Global Alpha hedge fund, and AQR's Cliff Asness—took their lumps. Asness wrote in a letter to clients during the tumultuous days of August, “Our stock-selection investment process, a long-term winning strategy, has very recently been shockingly bad for us and for all of those pursuing similar strategies. We believe that this has occurred as the very success of the strategy over time has drawn in too many investors.” Quant funds were forced to reduce their exposure by taking on less derivative-fueled leverage. Leverage doesn’t distinguish between I.Q.’s; it brings its magic and its pain to the smart and stupid alike.

Oddly, in retrospect, the crash of 1987 seems almost like a nonevent. There was no immediate economic recession, and the market finished higher for the year. Can we skate through again today?

John McCain has been reciting a quote attributed to Chairman Mao: “It’s always darkest before it’s completely black.” That may be where we sit now. In August, we had a credit panic akin to a run on the bank, but on a global scale. Even companies that had made mostly safe loans—like Countrywide, the nation’s largest mortgage lender—found that the short-term-borrowing markets were closed to them. But judicious financial management from politicians, regulators, and, most important, central bankers can calm credit panics. Indeed, Ben Bernanke’s largely symbolic mid-August move to lower the rate at which banks can borrow from the Fed quieted the markets’ demons for a bit.

The skittishness, however, was a symptom of larger imbalances—in the dollar, in global trade, and in American consumer debt. What we are going to discover in the coming months is that the underlying problems aren’t easy to solve, even with Fed rate cuts. Central bankers may find themselves impotent, because if lenders and borrowers have had their fill, even cheaper rates won’t do the trick.

The housing boom didn’t merely inflate home prices. Home equity extraction has accounted for as much as one-third of consumer spending growth at points during the boom, according to Ethan Harris, an economist at Lehman Brothers. Revenue at Home Depot and Lowe’s raged as people took money out of their homes in the form of equity loans to D.I.Y. Boat manufacturers, flat-screen-TV makers, lumber producers, and the railroads that shipped the goods all thrived—and hired. Of the 6 million jobs created since August 2003, when the job market started growing again, about 15 percent are attributable to housing and industries that benefitted from the boom, such as furniture makers and home-improvement retailers. In a more normal time, the housing industry accounts for about 5 percent of the nation’s jobs.

For now, borrowers with adjustable-rate mortgages will find it harder to refinance as their loans’ higher rates kick in. This month, a record $50 billion in mortgages will reset, according to Moody’s Economy.com. Retail banks won’t want to extend any more credit, even to customers who can afford the loans. Commercial banks are going to be nursing the hangover from easy corporate and commercial-real-estate lending for years. At the very least, they will have to increase their currently low ­reserves to cover loans that might go bad, thus hurting margins.

And even the private equity firms that aren’t losing out yet—the ones that can still persuade big banks to fund their deals—will have problems in the coming years. Buyout firms are going to have to manage companies, not just tinker with their financial engineering and flip them. Given the wary credit environment, the first buyout trouble spots are likely to be financial companies, like the already stumbling GMAC, the Cerberus-controlled lending arm of General Motors. But even the manufacturing and retailing L.B.O.’s are going to face—to put it in management-speak—challenges.

Is there a bright spot? The best Arnott can muster is that we could enter “a fairly significant bear market, but I don’t see a likelihood of a crash.”

While the stock market isn’t nearly as expensive as it was in 1987 or even in 2000, it’s not cheap. Yale economics professor Robert Shiller, who famously called both the Nasdaq bubble of 2000 and today’s housing debacle, pegs the price-to-earnings ratio of the companies in the S&P 500 at 27, computed using earnings over the last 10 years—a valuation that’s almost twice the historical average. What’s more, with corporate profits so high, there’s a lot of room for them to fall.

Apologists have failed to understand that it’s not much of an accomplishment that markets are more complex than they were 20 years ago. “Of course, risk is spread in a more sophisticated and diffuse way today,” says Grantham. “But it’s been accepted in a much sloppier way than any time in history. If it’s a bad enough loan in the first place and there’s enough of it, then spreading it around simply means contaminating a very broad spectrum of the financial world.”