As I described here, this is the weekend that the Treasury and the Federal Reserve decided to stop bailing everyone out. Secretary Paulson has been hinting for weeks now that we have to let capitalism work the way God intended it to. Which means: if you screw up, you die.

This is what we free-market conservatives have been saying we wanted all along, folks. We’ll be getting a chance to eat our own dog food. On balance, I have to say it’s a good thing… I hope.

We are now going to see the unwinding of the 158-year-old broker-dealer Lehman Brothers. The regulators are going to try this another way, and they decided to let Lehman die without the benefit of an overt and specific public bailout, as had been the case with Bear Stearns and Fannie Mae/Freddie Mac.

Lehman, which had been the fourth-largest Wall Street broker-dealer, will declare bankruptcy. Meanwhile, the third-largest, Merrill Lynch, will be acquired by Bank of America in a deal that values Merrill at about half what it was worth a year ago. The last two left standing, Morgan Stanley and Goldman Sachs, are strong and not in danger. (Not today, anyway.)

The AIG Companies, an insurance-holding group, is said to have sought a bridge loan from the Fed, as it seeks to raise desperately-needed capital by selling assets. AIG has sold a large amount of credit-default swaps, many of which may be triggered in the next few hours and days.

There have been reports that Merrill was ordered to sell itself, by authorities at the Fed. If so, someone must have wanted to pull off all the scabs at once. The blood is running in Wall Street this morning.

The Federal Reserve did announce last night that its various emergency-liquidity facilities would be significantly broadened and expanded in scope. If you’re so inclined (and I am), you can consider this another kind of bailout. But the Treasury and the Fed both refused to give Wall Street what the latter were looking for, which is an explicit public guarantee of Lehman’s distressed assets. It’s a completely new chapter in the Panic of 2007. (And 2008. And 200…)

Whether Lehman’s assets and trading positions are liquidated in an orderly or disorderly fashion will determine the tone of the next few weeks in financial markets.

And it could also determine the tone of the real-world economy, of jobs, goods and services, for the next year or more.

This morning, more or less as expected, markets are in shock. China and Japan didn’t trade overnight due to national holidays. Singapore, Taiwan and the Phillipines all saw sharp losses in their stock markets. European stocks are also sharply lower, and US stocks in Europe are trading several percent down. Best guess, US stocks will lose at least a few hundred points today.

US Treasury securities, meanwhile, are on the biggest rally in months. The dollar opened weaker overseas but has steadied. European and British monetary authorities have announced that they’re ready to support their money markets aggressively, should the need arise.

Hang on tight, everyone. This is a hurricane warning.

-Francis Cianfrocca