Right, you need to combine saving the financial system with systemic change. Letting them fail is equivalent to letting the system crash and the doing nothing.

I just dont understand why people talk about the "financial system". Its a bunch of banks and some of them fail. The only banks that failed are those who are bad.

A financial panic is not an avenging angel that slays the wicked and leaves the righteous untouched.

Without the possibility of a bailout, if, say, Citbank went under, this would not only screw Citibank’s depositors—most of whom were hardly in a position to audit Citibank’s books before opening their accounts—but also every bank that had loaned money to Citibank. If a bunch of people who deposited money with Citbank owe money to Wells Fargo, then Citibank’s failure hurts Wells Fargo. And if Citibank’s failure led the depositors at Bank of America to get nervous and withdraw their money, then BoA would be at risk even if it had been prudently managed up until the crisis. And then BoA’s and Wells Fargo’s creditors... etc., etc., etc.

Well yes some banks can be hurt in the process that are not acctully bad but history shows that in most cases bank runs happen on banks that are really bad. If you are a conservative bank you will acctully get a lot of cash (this happend in switzerland) witch you can then lend at high rates to banks that need it (if there wouldn't be the fed pushing the intrest rate down). Witch banks acctully are in a bad place and witch are not will be the task of bankers and private investors. The banks that are acctully good will probebly get survive. So yes there will be some collateral damage but that just cant be avoided in a cycle. It would be much better then the mess we are in know.

That all beeing said in a system where you have fractional reserve banking (witch is a bad idea anyway) there is a case (not one that I totally agree with) to be made that we need a "lender of last resort". But beeing a "lender of last resort" is quite diffrent then what the fed did. They literly flooded the hole bankingsystem with cash, knowbody knew what was going on, how will be saved who want, witch banks acctully are still liquid and witch will bust when the flow of cash stops. Why should banks lend to each other if the get free money. If I would get free money, I too would just sit around and wait until the worst is over. If every body does that we acctully have a bigger problem a long rescession instead of a short crash.

Uh, no. Read up on counterparty risk, credit default swaps, and the crazy interdependencies of financial institutions.

If bank A goes bad, institution B might have sold lots of CDS on bank A, requiring it to pay out more than it is able, so it goes under. Institutions C and D might have sold CDS on institution B, etc.

All the banks deal with and depend on each other. Also, in a bubble most banks are invested in the same scheme. When the bubble finally pops, all the banks get in trouble. So "financial system" is exactly the right term.

There are alot of banks and even Hedgefonds that did not invest into realestate (because the could not actully figure out what that stuff was worth and didn't buy them just because it was what "The cool kids where doing") and where not in trouble. An yes you are right the hole system has "trouble" but the system wont just crash. Everybody that is "bad" will go done and maybe some others will go down but if a bank had enough reservse and had not a shitlode of bad asseds the could survive the storm. The remaining good asseds of the banks that go bust will be liquidateted. The conservative banks can now make the money that the did not get in the boom years.