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added on 8/10/08 - It should be obvious by now that when Bernanke and Paulson decide not to rescue Lehman Brothers, they were overly optimistic about its impact on the US and European financial systems. Before anyone had the chance to catch a breath, AIG, Washington Mutual and Wachovia, to mention just the large ones in USA, teetered on failure, followed by similar threats in UK and other western european nations.

As explained below, the global financial markets have been living off the paper asset bubble created according to overly clever processes of wealth transfers. Companies kept selling and buying each other's papers, with apparent values asserted through various forms of "guarantees". Each each such buying and selling, someone earns commissions; the final buyers end up with dubious assets that have "value" only as long as the bubble system continues to maintain itself, but if one part fails, the damage spreads quickly throughout the system.

The countries that held most such papers must have lost heavily, both because of the drop of US currency and because of the failure of some of the issuers of the papers. These are the countries that ran huge trade surpluses, China, UAE, etc. Yet, in a way they caused the problem: their surpluses had to be recycled, and the companies that sold them the papers then use the money to buy other papers;it was the repeated sloshing of the tide of money that kept the bubble circulating, becoming bigger all the time, and making investment bankers and hedge funds rich.

How did the US finance industry mess up so badly? They are supposed to be so smart and experienced, and so inventive too, with many PhDs and MBAs, and used to teach the rest of the world how to operate. There was even a time when the Singapore government was encouraging people to put their money into unit trusts and other modern financial products, and new courses in financial engineering were started in NUS to copy the Americans. To have them crash like this is not just embarrassing to them; it is embarrassing to all the people in the world who wanted to humbly ape them.

You must have heard many explanations and inside stories about what happened, and they (like all those brilliant financial advisors) only left you more confused than ever. Now let me try to explain it, starting from the beginning.

Let's suppose I and my friend X have a company with $1M of assets each, and the two companies exchange $1M of shares, after which each company has $2M of assets, doubling our wealth, without actually producing anything in addition.

We then each issue $2M of bonds, guaranteed by the assets of the company. After selling the bonds, each company has

$1M of the original assets

$1M of shares of another company

$2M of cash

In case buyers have doubts about my bonds, I get my friend to guarantee them, while I guarantee his bonds; so the papers look really secure - guaranteed by the issuer's assets (now $4M) AND by another company with $4M of assets, half of the 8M combined assets being cash - surely these look like trustworthy guarantees? So the rating agencies rank my and his bonds AAA...

As you can see, starting from the original $2M of assets of the two companies, we have created something four times the size, 75% being just air in a bubble. Now consider the possibility that the original $2M of assets may themselves be air in a bubble to begin with...

Now imagine while I did profitable things with my cash, my friend went and spent his $2M on drugs, women, gambling, etc, and could not keep up interest payment on his bonds. He declares bankrupcy, and the bond holders ask me to make good on my guarantee, so I lost $2M of cash, while his company's shares became worth 0 - my company is down to the original $1M of assets, but owing the bond holders $2M; at the same time, his guarantee of my bonds also becomes useless, and rating agencies cut my rank from AAA to junk, so that any future bonds I issue have to be at much higher interest. I could not raise any new money by issuing shares or bonds, so I too go bankrupt.

This is what happened in USA, on a scale a million times bigger.