Making sense of the crisis

With theories and counter-theories flying in all directions, making sense of the ongoing financial crisis and the bailout package is difficult. Here is an attempt in about 257 words!

In light of the recent events and faced with the difficulty in locating and pricing counter party risks, banks have almost stopped lending. Even the inter-bank lending market has dried up, as "trust" has evaporated. The values of asset backed derivative securities have collapsed, forcing Wall Street firms and insurers to shore up their margin and other liquidity requirements. In the absence of credit, the shares of these financial institutions have plunged.

The Paulson Plan sought to prop up the falling derivative and share prices through government purchases of these securities, thereby creating an artificial demand for them. The problem with this approach is that of pricing these distressed assets, many of them virtually worthless, and the failure to differentiate between fundamentally "good" and "bad" assets. Incentives get distorted and moral hazard accentuated, raising the possibility of asset stripping once the prices recover on the back of the artificial demand and tax payers may end up paying a higher than required cost.

Instead, why not inject credit into the ailing institutions and in return take equity stakes in them? The credit squeeze would be addressed, financial institutions and the market would get breathing time to get their books back in order and regain confidence and trust, and the tax payers are more likely to get back a substantial share of their money when the government finally offloads its equity. Besides, this would also combat moral hazard by providing a greater chance that the excesses built up in the form of insolvent institutions and their worthless assets actually fail and the reckless and greedy investors and borrowers are punished!

Update 1
Richard Posner has this explanation of the crisis.

Update 2
Ben Stein nails down the crisis to lack of savings among Americans.