It started with the burst of the housing bubble... and with it, talks of a possible financial collapse. The end of growth in the real estate markets had been something people relunctantly anticipated for several years. Since the 1950's, when a larger portion of the American people became first time home buyers,
mortgages have been a stable backbone of investment by many American banks. If you compare the value of the home to what you actually pay over the life of the mortgage,
upwards of 66% of what you pay is pure interest.
We won't get into all of the details on the mortgage side, but short term profits became a priority over proper long term investments and a lot of people were getting homes they couldn't afford. So, you have all of these mortgage backed securities
(1000's of mortgages bundled and sold together as one)... which are usually profitable, being sold from one investment company to another. And this helped precipitate the housing collapse... that is to say, mortgages use to be approved based on your ability to pay back the bank giving you the loan. But, I'm more likely to sell someone a home they can not afford, if I know I'll be selling the responsibility of collecting those payments to someone else.

On Monday, March 10th, 2008, the rumors began about the financial strength of
Bear Stearns, one of the smallest "major banks" and heavily entrenched with subprime (less than prime/A-rated credit) mortgages. Once rumors emerged, market confidence dwindled and the value of Bear Stearns' stocks began to fall. The CFO calls around to the ground level guys and learns that people believe that Bear Stearns is out of money. Its like a snowball.
Once the rumor of a bank not having money is out there, the truth is irrelovent. Everyone wants their money out, and no bank is able to pay all its investors/customers back at the same time.
There were enough banks requesting their money (inter-bank lending) that by Marth 13th, Bear Stearns didn't have enough reserve capital to open the next day. So, they turned to the Federal Reserve Bank and
Timothy Geithner. Geithner wasn't an interventionalist and wanted to let them go under, but while going over their books, he discovers how many different financial institutions Bear Stearns has sold guaranteed insurance on bonds to. They were indebted to too many people to fail. Geithner saw the possibility of "
systemic risk"... that is to say, the bankruptcy of Bear Stearns would severely harm many other institutions, not just itself.
Realizing that the fall of Bear Stearns could potentially bring on another
Great Depression, Tim Geithner calls his boss and Federal Reserve Chairman Ben Bernanke. But Bernanke knows the Fed cannot lend money directly to an investment bank. So Bernanke (pictured below) bends the rules by striking a deal to lend money directly to JP Morgan Chase, who would then in turn send money to Bear Stearns. To give you a sense of the importance of this deal on the economy, all of this... Bear contacting Geithner, Geithner and the Fed going over Bear Stearns' books, Geithner getting Fed Chairman Bernanke involved, Bernanke contacting JP Morgan, JP Morgan going over the books and finally agreeing to terms with Bernanke... all of this was done after hours Thursday before the start of the business day on Friday.

But, Bernanke's plan backfires... it only spotlights Bear Stearns financial woes. Technically, Bear now had the money, but its all about perception: the fact that this level of intervention was needed singled out Bear Stearns and their stock value plummetted.
This caught the eye of then-Treasury Secretary
Henry Paulson. Paulson is a free market Republican who was formerly the CEO of Goldman Sachs. Paulson wasn't a regulator or interventionalist but ultimately, he left that call up to the Fed (Bernanke), but from this point on, Henry Paulson would be involved. On Saturday, March 15th, all of Bear Stearn's former competitors are perusing their books and see far too much debt to want to take on. After working all weekend without getting a deal finalized, Bernanke finally creates an acquisition of Bear Stearns by JP Morgan by
guaranteeing $30 Billion against Bear's mortgage backed securities.

At the US Department of Treasury, Henry Paulson was relunctant but went along. He made it quite clear to the other banks that this was not going to happen again. It went against his free market philosophy: the markets punish those who do business poorly and rewards those whom excel. The Bear Stearns stock at this time was hovering around $30 per share and JP Morgan was offering $4. The people within Bear were expecting maybe 20, but Paulson calls over to JP Morgan and tells them to offer $2. Paulson was not in favor of a bailout to begin with, and didn't want to give Bear any rewards. He wanted this bailout to hurt, and again, wanted to send a clear message to all the other banks... there will be no handouts.
But Bear Stearns was not alone, through the summer of 2008, losses for many other financial institutions began to mount. More than a combined trillion dollars in wealth disappeared from our economy over that summer. Then in July 2008 came news of Freddie Mac and Fannie Mae. Originally created by the US government, Freddie and Fannie were the largest private mortgage giants in the world. Everyone owns a piece of Freddie and Fannie... they held $5 TRILLION in mortgages and had lost 60% of their stock value. Again, the fear of systemic risk trumped the philosophy of free markets, Paulson doesn't just give loans to the two, but nationalizes the two mortgage giants... they are now owned by the US government. But, it sent a major shockwave to the financial sector... if Freddie and Fannie could fail... ANYONE could fail.
Only DAYS after bailing out Freddie and Fannie, that fear became a reality with the news of the inevitable collapse of Lehman Bros... a bank larger and even more interconnected than Bear Stearns... and it was clear, it was going to get worse, before it got better.