Market mayhem goes to 11

Government bailout of AIG and money-market fund freeze turn it up a notch

While Silicon Valley startups continue to create new products, raise new rounds of capital and, in some cases, be acquired by new bosses, the Wall Street financial system looks shakier than ever.

That's after news today that the government stepped in to save insurance giant AIG with an $85 billion loan, and a manager of a New York-based money market fund said it was freezing redemptions of its shareholders.

The money market fund has for decades been regarded the same as cash, and when you tell investors that the dollar they put into a cash account is now only worth 97 cents, it's a serious blow to confidence.

Not that anyone involved in the financial services industry has much confidence these days. When storied investment banks like Lehman Brothers and Merrill Lynch can have their assets sold for a fraction of what they were worth a year ago, it's officially a bust.

Now the government is looking for a buyer for Washington Mutual, the biggest U.S. holder of mortgages. Once it's sold or goes bust, and it's real estate assets are marked down, the housing market is in for another round of pain.

While all this old money gets destroyed, however, new money is being put to work.

Last week I watched the startups at the TechCrunch 50 confab present their new companies with the enthusiasm of Forty-Niners. The entrepreneurs at DEMO did the same. This week, it's the Going Green conference for alternative energy companies near San Francisco. Next week, it's Web 2.0 -- live from New York.

Except for the lucky few who can bootstap their own efforts, all of these innovative young companies exist because of angel or venture money. This is what has made the U.S. technology sector as durable as it is -- the willingness of investors to risk capital on unproven ideas.

The venture industry, of course, isn't immune to fallout from the mortgage meltdown. The dry spell in IPOs that has existed all year won't reverse itself overnight, which means acquisitions will remain the prime exit for venture-backed companies.

That in turn means average venture returns will inevitiably go down, since M&A exits don't produce the kind of market caps that an IPO does. At the same time, big public companies will see sales go down as cash-strapped consumers retrench, which may affect the acquisition.

 But money will continue to find its way to young companies, and not just because of the risk appetite of angel and venture investors. The limited partners that invest in VC funds are seeing other investment vehicles get hammered.

In an environment where the value of titans like Lehman, Merrill and AIG -- and let's not forget Bear Stearns, Fannie Mae and Freddie Mac -- can collapse in short time, betting on "three guys, a dog and an idea," as some VCs describe their trade, doesn't look so risky.