Finally, one of the most extraordinary weeks in stock market history is coming to an end. The week began with Lehman Brothers (LEH) filing for bankruptcy, followed by an $85 billion dollar government bailout of insurance giant American International Group (AIG), and concluded with the federal government announcing plans to take bad loans off of private company's balance sheets as well as halting short selling in financial stocks for 10 days (with a possible extension). The market reaction was deep depression followed by euphoria, with 2 days of 4% drops mixed in with 2 days of similar gains. With such massive federal intervention, did we just witness a failure of capitalism, or can we not afford to let it work? Who's to blame for this mess and are these the right steps to prevent a redux? What does all this mean for investors, particularly Magic Formula investors?

A Quick Synopsis of the Problem

First, a quick synopsis. As we know, banks got lax on lending standards, and for some reason believed that a below-prime borrower that could barely afford an introductory rate on an adjustible rate mortgage (ARM) was magically going to be able to afford rates 5-6% higher in 3 or 5 years. Now that those loans are resetting at higher rates, foreclosures are rising leading to increased loan defaults. When 15% of a bank's loans default, and the bank had only provisioned for 3% of them, that's bad news.

Exacerbating the problem is the incredible amount of financial "innovation" that occurred this decade. Investment banks greedily bought up these mortgages from lenders, and then went to financial culinary school, slicing, dicing, and combining them into alphabet soup derivative securities like MBSs (mortgage backed securities), CDOs (collateralized debt obligations), and so on. These securities were then bought by all sorts of companies, from banks to insurance companies to electric utlities. In effect, the mortgage crisis is putting all of those buyers at risk now. It's clear why Warren Buffett referred to these securities as "financial weapons of mass destruction" back in 2003.

The daisy chain doesn't end there. AIG got into trouble because it sells credit default swaps. In effect, this is insurance against another company going bankrupt. You can see where this is going. With so many firms exposed to this mortgage mess, bankruptcies may skyrocket, leaving the insurers like AIG with a tidal wave of claims to cover. If it can't meet those obligations, bankruptcy is imminent.

Why Not Let the Market Solve It?

So that's the synopsis. It's disturbing how fragile the financial pillars of the economic system really are. Is this a failure of capitalism? I don't think so. In a pure capitalistic system, the banks holding the mortgages would certainly fail, and some of the insurers and other firms exposed to them would also go belly-up.