[Estragon]

  - Credit markets seized up because no one could tell who 
    was insolvent.

  - Massive outflow of foreign capital from the US as  
    investors realized what a mess the US financial system
    must be in.
    

I'm in favor of letting a bank like Lehman Bros collapse despite that. The most important thing for day-to-day economic health is to make sure no one loses retail deposits, and Lehman Bros wasn't even in that business. But what should have followed is much more intrusive regulation and oversight of the financial industry to determine exactly who is insolvent and arrange an orderly writedown of people's bad financial positions. Unfortunately, the disproportionate political power of the financial industry made such a policy impossible to implement. (See the recent book Confidence Men.)

[bd_at_rivenhill]

The most important thing for day-to-day economic health is to make sure no one loses retail deposits

You're ignoring the money market here. I just looked up some numbers, and Forrester research peged the amount of deposits at FDIC insured banks at $6.9 trillion at the end of 2007 (http://www.forrester.com/rb/Research/industry_essential_us_r..., although the number of insured dollars is probably a fair bit lower than that due to limits on the size of insurable deposits), while the Institutional Money Market Funds Association gives $3.6 trillion in money market funds. Money market funds are marketed as being equivalent to bank deposits (down to the ability to write checks against them) and many retail investors don't understand that they aren't insured.

[iqster]

Good response.

I recall reading (think this was in Too Big To Fail) that the deciding powers were afraid that if there was another Lehman, cash would stop coming out of the ATM machines. This is what prompted AIG and a few of the other shotgun marriages.