The bailout of AIG (NYSE:AIG) was supposed to calm investors fears of a financial collapse. But instead it just exposed just how bad things are, says Chuck Butler in Daily Pfenning. Foreign investors, who the US relies on to finance its huge deficits, have started to move their funds out of the US. This means lower living standards for US citizens, thanks to higher borrowing costs and a lower US dollar…

More from Chuck:

And unfortunately the bad news on Wall Street just keeps coming. I heard on the radio this morning that Morgan Stanley is very close to reaching an agreement with Wachovia to be bought, and Washington Mutual officially put themselves on the sale block. Wachovia has a big presence in St. Louis after swallowing A.G. Edwards, but I question if they are healthy enough to take on Morgan Stanley. Sounds to me like they are just desperately trying to grow big enough to be considered ‘too big to fail’ by the Fed. Things are definitely getting pretty crazy out there.

Central Banks around the globe took coordinated action to try and soothe the markets, pumping almost $250 billion into the credit markets. Finance officials are struggling to try and restore confidence in the markets as banks have stopped lending to one another. As I mentioned yesterday, Bernanke has the printing presses working double time. But even ‘Helicopter Ben’ won’t be able to restore investor’s confidence.

Not to sound negative, but I truly believe we have just started to see the fall out. Yesterday the unthinkable happened as a huge money market fund ‘broke the buck’. The nation’s oldest money market mutual fund, The Reserve Primary Fund, traded below $1 because of its exposure to debt from Lehman Brothers (NYSE:LEH).

The event marked only the second time a money market fund has broken the buck. The fund had $62.6 billion in assets as of Sept. 12 and held $785 million in Lehman Brothers short-term debt, representing 1.2% of total assets. Shares of the money market fund are now valued at 97 cents.

The Credit Default Swap market will likely start to take center stage in the financial market meltdown. These CDS’s are basically insurance policies written by companies guaranteeing the holders of debt instruments against default. I heard there are over $70 trillion worth of these outstanding, but it isn’t clear just who has written all of these. The CDS market was what brought down AIG, as they had sold CDS to investors around the globe.

AIG decided to get into this market a few years ago, and quickly became one of the biggest players. But they didn’t fully understand the risks associated with this market, and looked at it the same way they looked at homeowners insurance; figuring that they just needed to sell a lot of insurance policies so that a loss of one home would be made up by the premiums earned on all of the other homes. But a fire at one home typically doesn’t spread to all other homes, while a default by one bond issuer quickly turns into problems for other bond issuers.

So when things started going bad in the mortgage markets, losses on these Credit Default Swaps began to accumulate out of control. And now you and I are on the hook for all of these. This is why Paulson and Bernanke felt it was necessary to bail out AIG, foreign governments and investors own many of these CDS insurance policies. If AIG was allowed to fail, these foreign investors would have been burned bad, and the US financial system is dependent on the continued inflow of capital from these overseas investors.

But foreign investors obviously have begun to lose faith in the US, and will continue to demand higher compensation for providing the money the US government and economy depend on. That in turn will translate into higher interest rates here in the US, and a lower US$. The average American will face lower living standards as borrowing costs are pushed higher and the dollar is pulled lower.

Source: Sanity returns to the currency market…