TM does not back up all the system files. It does back up your preference files.
Bob, I'm not sure I'm understanding you, but as I read you, this is not correct.
Time Machine backs up EVERYTHING. Applications, system files, preferences, user data, photos, music -- EVERYTHING that is on the hard drive, including invisible files. Every last byte of it (file-by-file not sector-by-sector, but still).
It then adds an "iteration" of what's changed. So if your original state of the hard drive can be expressed as "A", and whatever has changed since then can be expressed as B, then the 2nd backup is A+B1, 3rd backup is A+B2 and so forth.
Time Machine doesn't actually *ever* delete the original backup (the "A" state). It deletes the oldest "B" states. The only time the "A" state gets erased/replaced is when a new "A" state is created (by changing the hard drive substantially enough like by a system update). This is why Time Machine doesn't "recognise" your hard drive when you upgrade from Leopard to Snow Leopard and you have to do a new full backup.
Time Machine conserves space by folding the hourly updates into a daily update after 24 hours. After 30 days, it folds the oldest daily backups into a weekly backup. These weekly backups are what start getting deleted (oldest first) after the hard drive gets close to full. The A state is left untouched.
Hopefully that clarifies things a bit.
PS. Your suggestion to exclude certain "busy" folders such as the download folder from TM is a particularly good one.