Collapse? Not quite...

It's been quite awhile since I wrote anything, because I've been trying to wrap my head around the financial crisis taking place.  The following is my understanding of what has been happening the past few months...

My impression of the situation is that the FED set a somewhat dangerous precedent when it bailed out the investment bank Bear-Stearns, essentially establishing the public perception that gains from taking risks are private, while the losses are public.  This would, naturally, increase moral hazard.  If the FED is perceived as being only a little bit more likely to bail a failing firm out, a firm will be marginally more likely to make risky business-decisions.  Which is especially bad in troubled economic times...

Fannie and Freddie failed because they agreed to underwrite risky subprime mortgages after the government, in 1992, essentially mandated that the two organizations underwrite subprime mortgages so that low-income bad-credit home buyers could have a chance at a part of the American dream.  Lo and behold, when the interest rate shot up last summer, and subprime mortgage dependent home-buyers started defaulting left and right, these securities they had underwritten became essentially worthless.  Bye-bye, Fannie and Freddie.

The FED wasn't going to make the same mistake with Lehman Brothers, and it (wisely, I believe) allowed that investment bank to fail.  Everything would have been peachy, except that money markets started essentially drying up because investors were scared.  For instance, the LIBOR doubled overnight, which is historically unprecedented, and banks actually stopped lending to each other, which is unheard-of.  AIG insurance had previously issued many credit-default swaps (or subprime mortgages), and as a result was having to pay the collateral in massive amounts because they were losing their bets in massive amounts.  AIG started frantically borrowing money in the hope of paying off their debts from the credit-default swaps, to such an extent that its credit-worthiness rating was downgraded.  Remember commercial paper?  A substantial portion of the commercial paper held was issues by AIG, and thus a whole lot of people ran the risk of getting screwed if AIG became financially insolvent.  Money markets would have dried up  So the financial markets froze up, because a lot of people were invested in AIG's debt, and as a result the velocity of money plummeted.  Bernanke and Paulson concluded that it was a better option to loan AIG massive quantities of money at a high interest rate (making a pretty penny if AIG pulled through) than have the economy potentially collapse, and that pretty much leaves us where we are today.  Whew.