A Clear Description of This Mess We're In
He lays out the scenario pretty much as I have here. The only thing I would add is the credit derivative layer above all this, which adds to the "spooking" effect he mentions. (This is just another layer of complicated financial finagling that is supposed to spread the risk even further, which it may in fact do, but it also adds to everyone's euphoria and ultimate insecurity, just as Average Joe describes.)
I think what is making this all the more spooky, is that some of the most sophisticated number-crunchers in the world (e.g. the Federal Reserve, the BIS, and all those analysts trying to decipher the stats) can't give us an idea of how deep and/or wide this situation is.
Some will answer that the market is handling this just fine, that the players in this game are very aware of the risks in the long run, and they have covered their butts, or if not, they will be allowed to fail. I answer that to believe this is to ignore the potential for disruption of world economic equilibrium and the LLR (Lender of Last Resort) role of the Fed and the US Government, upon which the markets are counting--and probably rightly so.
In other words, the high-rollers know that the US Government will not let the economy tank just because a few players took too much risk. This is what economists refer to as "moral hazard," i.e. a dichotomy whereby a market player's human conscience comes in conflict with his/her human nature.
To spell it out, bankers and financiers know that to take great risk is dangerous; but at the same time, some have the gambler's faith that they will beat the odds and/or that the consequences of their actions only involve themselves--or that they can count on the US Fed or Gov to bail them out, in which case it becomes quasi-criminal, but not prosecutable without a statute to hang it on.
[Thanks to gamblinggates.com for the image.]
We seem to be at an intermission in this show. Stay tuned. The Fed will probably try to resist action, to stay on course, and to let the system shake itself out of this, but I still believe they will be under pressure from government officials to either lower rates or perhaps inject cash into the system (which some number crunchers say has not happened yet, in spite of all the noise about lowered discount rates and repurchase-agreement cash infiltration).
If they cave to pressure, I would fear for the dollar and would see hope for gold to rise eventually, as speculators make a last-ditch effort to save their purchasing power. Beyond that, who knows what regulators and markets will do.