Excerpt from COMPLICIT: How Greed and Collusion Made the Credit Crisis Unstoppable, by Mark Gilbert with permission from the publisher Bloomberg Press (February 2010). Part 1 of 2

By Mark Gilbert, London bureau chief and global capital markets columnist for Bloomberg News.

Where did the money come from? Where did it go? How was thisallowed to happen? Who is to blame? These are the key questionssurrounding the credit crunch that has engulfed the global financialsystem.

The answer, in part, is that there wasn't anywhere near as muchmoney as there seemed to be. And because it didn't exist in the firstplace, the money hasn't gone anywhere. It was all an illusion, althoughthe economic consequences of its disappearance turned out to bevery real indeed.

As to how it was allowed to happen and who is to blame, in asense the honest reply is that we all allowed it to happen, and we'reall to blame, either as active accomplices or complicit bystanders.Society as a whole made a collective, unconscious decision to allowthe banking system to grow unchecked because the tangible benefitsthat seemed to accrue from unbridled capitalism outweighed theintangible hazards that might accompany this dangerous test ofcapitalism's limits.

The global financial authorities -- the elected politicians who decreethe legal framework within which finance operates; the unelectedcentral banks charged with tending the economy, the regulators responsiblefor creating and enforcing safety rules; the money managersentrusted with nurturing the future incomes of widows, orphans, andhordes of other savers; and the people paying themselves millions ofdollars to run the investment banks -- all looked the other way. Theyoperated under the belief that the monetary benefits accruing tosociety from incessant, unprecedented, and essentially unregulatedgrowth in the securities industry more than outweighed any of theattendant risks. In other words, the financial community, through a deadly combination of greed and hubris, fouled its own sandpit.

We have all read about what happens when an investment bank loses money on a trade -- the aftermath resembles the crime scene of a particularly gruesome murder. Heads roll. The survivors analyze event details with forensic precision, scrutinize mistakes, tighten procedures, and (allegedly) learn lessons.

However, when an investment bank makes money on a trade, there is no corresponding attempt to understand the mechanics ofthe success. Participants slap backs and enjoy recalculated bonuses.The trader tries to repeat the achievement and the manager attemptsto take credit for nurturing such a phenomenal talent, but the bankmakes no attempt to investigate whether the triumph was the resultof sound judgment or sheer luck.

Profits rolled in at the height of the credit boom. Citigroup ( C - Get Report), forexample, generated total net earnings of more than $90 billion betweenabout March 2003 and November 2007. Banks congratulated themselveson their cleverness. They did not question whether their goodfortune was mere happenstance or, as it turned out, the result ofmaking bigger and bigger bets that were lucky rather than smart,in a near-perfect market environment created by providence, notproficiency. That somnambulism proved fatal. When the luck ranout, the lack of skill was laid bare.

Traders put bank capital, and therefore equity, at risk every timethey execute a transaction. Without understanding a trader's trueskills, though, a bank can't evaluate the true risk it undertakes whenit puts capital behind that employee's trades. Because cash seemedso freely available during the credit boom, banks paid zero attentionto managing the traders who used bank capital to seed increasinglyleveraged deals.

Banks paid little attention to inputs, a blind spot common tofinancial institution managers and regulators during the credit boom.If market overseers had asked penetrating questions about how tradersgenerated fantastic profits, they surely would have realized that thefinancial system was mushrooming into an enormous inverted pyramid,with a tiny triangle of real money at the base trying to buttresstowering layers of debt and derivatives. However, banks and regulatorshad little incentive to ask probing questions. Banks were gettingrich. Regulators, for their part, held to a blind faith that banks mustbe doing something right to amass such riches. So long as they keptat it, profits would continue to accumulate.

Because banks don't spend enough time investigating where andhow they make money, they don't know when--or how--they shouldchange in varying market climates. Investors, too, are in the dark.Because bank earnings reports are masterworks in opacity, even themost conscientious investor would struggle to accurately dissect theinteraction between profitability and probability.

Investment banks generated much of their credit boom profitsby using the derivatives market to bend and shape the price ofmoney. The new breeds of complicated derivatives, however, hadn'tbeen through sufficiently severe crises for traders to understand howthese investments might behave under pressure.

The lessons of history should have made the bankingcommunity slow to trust untested investment strategies. In the runup to the 1987 stock market crash, banks automated trading decisionsfor program trades and portfolio insurance, using computer programsthat could exploit price discrepancies faster than a humantrader could. The computer programs could also follow predeterminedselling levels to protect against losses. Individually, the new techniques worked well.

Collectively, they proved disastrous, as they prompted everyone to run simultaneously for the same exit at the first sign of trouble.

Mark Gilbert is London bureau chief and a columnist on global capital markets for Bloomberg News. He has been with the company since 1991. Mark was born in Liverpool and graduated from Kings College, Cambridge, in 1989 with a BA (Hons) in philosophy. He was nominated as a finalist in the commentary category of the U.K. 2006 Business Journalist of the Year awards, and holds a Malcolm Forbes Award for Best Business Story from the Overseas Press Club of America. When he's not watching the markets, he plays bass guitar in a rock band.