Main reason to not let them crash is because of the web of counterparty agreements that could result in other, perfectly sound firms also crashing.

As a specific example, the business unit that got AIG into fatal trouble was one that had issued a whole raft of credit default swaps over other institutions' bonds. These pay out if the bonds turn out to be junk but in the meantime, maintain an investment grade credit rating for the bonds.

If the guarantor collapses, so does the guarantee and so does the credit rating, resulting in the bond issuer having an urgent need to obtain more capital - which at present is largely unobtainable on any reasonable terms.

While nobody knows for sure, it is currently estimated that the value of credit default swaps outstanding is $58 trillion. The market in them is regulated by nobody and nobody knows who's holding most of them, http://money.cnn.com/news/newsfeeds/articles/djf500/200809231755DOWJONESDJONLINE000675_FORTUNE5.htm

It is misleading to think of rescues so fare as rescues of "the bank". They are really rescues of the bank's customers and result in shareholders losing all or most of the value of their equity and the executives responsible for the mess losing their jobs.

The current mounting criticism over the new Hank-Ben $700 billion rescue plan is that it won't impose any penalty on executives and shareholders of banks that it rescues. There is growing pressure for rescuees to cede a good chunk of their equity to the government in return for the money.

This is apparently what happened in a similar case in Sweden some years ago. When the Asian financial crisis hit in 1997, the South Korean government ended up owning the banks that it rescued - not through any ideological inclination to socialism, but as a quid pro quo for the cash. It has been progressively selling them off ever since.

The problem with this in the US is that it clashes with the great libertarian ideal that the government should get out of the way and let markets solve the problem, not that government should buy up stressed banks.

I't's hard to be sure what will happen. We will have to wait and see.

MikeM
What is happening is that Hank Paulson’s $700bn rescue package has run into difficulty on Capitol Hill. It required Congress to abdicate its responsibility by giving the Treasury secretary a blank cheque. Apparently the bill submitted to Congress even had language in it that would exempt the secretary’s decisions from review by any court or administrative agency.

Another example of the Bush administration’s dream of a unitary executive.

MikeM
Why not help by capitalising the institutions that are burdened by distressed securities directly, rather than by relieving them of the distressed securities?

Secondly, the heart of the problem is the heart is the housing market. So many mortgage cash flows have been sliced and diced and spread over different kinds of securities owned by holders all over the world -- a big stumbling block to the private sector trying to manage its way out of a hole. As Holman W. Jenkins Jr.says in the Wall Street Journal:

It's not clear the new agency offers a solution to this problem. It would probably have to buy the entire outstanding stock of questionable mortgage debt before it would have any hope at getting at the underlying collateral, i.e., houses. But then it would become the world's biggest, most troubled landlord and biggest foreclose on homes. Politics would intervene -- and any potential taxpayer gains would likely be frittered away to keep nonpayers in houses they can't afford.

Jenkins advocates demolishing houses!

Peter,

Some commentators have likened the Ben-Hank plan to the kind of knee-jerk over-reaction that followed 9/11. There is general agreement that something needs to be done but little agreement that something stupid needs to be done.

We'll see tomorrow morning our time whether a consensus has transpired overnight.

Anon,

This started with the housing market, but that is no longer the heart of the problem. There is around $11 trillion of housing loans outstanding, but $44 trillion of that consummate gambling chip, the credit default swap contract, plus a whole raft of other exotic instruments.

http://www.latimes.com/news/printedition/front/la-fi-regulate25-2008sep25,0,872846.story

These all stand or fall on the basis of whether the counter-parties maintain their credit rating. For reasons that go back to the debacle in the sub-prime housing market, the credit rating agencies have lost a lot of credibility and ratings generally are being viewed with suspicion.

If the CDS market takes a tumble it could become ugly.

The US government will end up having to do what governments always do in financial crises: use taxpayers’ money to pump capital into the financial system.

As the negotiations over the $US700 billion bailout plan to restore credit markets continued Washington Mutual, the largest US savings and loan bank, was taken over by authorities and its deposits auctioned off. JPMorgan Chase & Co said it had bought the deposits of Washington Mutual Inc.

Doesn't that mean that a deal hasn't been reached in Congress re the Paulson bailout plan? That allows the U.S. Treasury to buy toxic waste for much more than it was worth — and gotten nothing in return. Nobody on Capitol Hill, it seemed, was happy about that.

I thought that there had been an agreement in principle? A Congress plan that revised the Paulson one. The deal---ie the Congress Plan---- would give the money to the US Treasury in instalments rather than a $US700 billion lump sum the Bush administration wanted. The deal would also allow the government to take part-ownership of banks and ban companies that sell toxic assets to the government from paying massive "golden parachutes" to executives being fired.

What has happened?

peter
The Congress plan has to be a bipartisan plan. Democrats won’t pass the plan without votes from rank-and-file Republicans — and as of Thursday night, some of those rank-and-file Republicans were balking.So the votes on the floor of Congress are not there.

Apparently a group of House Republicans (small government, free market) had circulated an alternative plan that would set up an emergency insurance fund for financial institutions, instead of the proposal to purchase troubled mortgage assets presented by the Bush administration.

McCain is in there somewhere stirring, trying to look as if he is in charge. It sounds as if he is backing the rebel House Republicans. I have no idea why.

The New York Times has a good account.

Anon,
McCain's plan was to be the leader who had put aside presidential politics to help broker a solution to the financial crisis.That meant being a leader at consensus building, and as the real face of bipartisan politics.

It seems as if he stumbled and did very little. The New York Times says that McCain:

now finds himself in the middle of an ideological war that pits conservative Republicans, loath to spending so much taxpayer money on Wall Street, against the Bush White House, which, with the support of Democrats and a sizable number of Republicans, sees a bailout package as essential to averting a potential economic disaster.

Is he supporting the rebel Republicans? Or laying low?

Anon,
it was only a week ago that McCain was saying that economic fundamentals were strong despite the brewing Wall Street meltdown.

Whether bailouts achieve there desired aim of restoring confidence in the markets or not, the US will still have a major problem dealing with it's massive debt now standing at 370% of GDP. The debt crisis is showing up in the US credit and money markets - libor, t-bill, etc. Yeilds on 1 month T-bills are now 0.31%. With US infaltion at around +5%, investors are loosing capital parking their money there, revealing real fear in the future directions of the US money and credit markets.

The Govt and Fed are playing a confidence game. As economic growth in the US has been very dependent on cheap credit for business, housing and consumer spending, they're attempting to restore confidence in these markets in order to save the economy from a protracted downturn. They may achieve this in the short term, however I feel that the credit fueled boom dating from the 1980's has ended and there's going to be a significant contraction in public confidence and economic activity. The credit cycle normally peaks with a orgy of speculation and fraud as we've seen in subprime lending.