This will no doubt end up in GD, but here’s my take on the problem. I’m no economist, but I read and think I have a general handle on the problem:
[li]Laws passed during the 1990’s–particularly the Gramm-Leach act–tore down some of the regulatory walls erected between the various financial sectors in the wake of the Great Depression. This allowed banks, for example, to sell financial instruments based on revenue they received on loans, such as the common home mortgage.[/li][li]Banks (and anyone working in the housing finanace market) now have a greater incentive to sell mortgages, so credit in general becomes easier to come by. This has a threefold effect: (1) more borrowers with poorer credit ratings receiving loans–particularly adjustible-rate loans, which ratchet up the interest rate after some introductory period–(2) an increase in average home price–if credit is easier to obtain, sellers can increase the price on homes they put on the market–and (3) more speculative purchases in the housing market, i.e. people are buying properties they don’t intend to live in or borrowing on terms that assume the property is easily disposable.[/li][li]The credit risk starts to catch up with reality. ARM rates ratchet up and suddenly that cheap loan doesn’t look so cheap anymore, or changes in the job market cause a loss of the personal income required to maintain the mortgage. By this time the original mortgage has been cut up and resold a few times in the securities market (in ways that often hid the original credit risk), so the connection between the person making the payments and the person receiving the income is tenuous at best. In any event, more people begin to fall behind on their loans, or outright default, and are finding it difficult to renegotiate because the paper isn’t held by their local bank any longer.[/li][li]As the easy-credit assumptions behind many of these securities is exposed, credit starts to tighten, which means housing prices must fall because buyers can no longer get the money they need to purchase expensive homes. This causes speculative investors to bail–exacerbating the problem further–and even those who own their home are in danger of being underwater and facing a hiked ARM payment, indicators that increase the likelyhood of a future forclosure. Defaulted loans is basically what did in Fannie Mae and Freddie Mac, as these companies disproportionally serve the sub-prime lending market[/li][li]Because many of these securities are not traded on an open market–i.e. they are traded on an unregulated market–the requirements to reveal the details of the capital supporting them aren’t as stringent as, say, on the stock or bond market (in short, they are easier to undercapitalize). So it’s easier to hide the losses for a period of time. This means that when losses are reported, they often have a devastating effect on what market there is. This is what knocked out the major investment firms like Bear-Sterns, Lehman Bros., etc.[/li][li]By law (and common sense) investment firms are required to carry insurance against these types of failures. These insurance contracts–you can thank Gramm-Leach again for this–can also be divvied up and traded as unregulated securities, hiding their potential risk. AIG is being forced to pay off on more of its policies than expected; the losses are mounting, and there is even more worthless paper being held by investors.[/li][li]The US federal government has decided that some of these firms are just “too big to fail”; if AIG filed for bankrupty, the amount of worthless paper in the hands of investors would likely crash more investment groups around the world in a domino effect. Thus the Fed is “loaning” AIG some $80 billion dollars to cover the losses and receiving 80% of the company in return. Similar logic is behind the earlier bailouts of Fannie Mae/Freddie Mac and Bear-Sterns[/ul][/li]Again, I’m no expert, so please feel free to correct.