I wa watching a bit of C-SPAN this afternoon while at the gym and I was amazed at the claptrap some of the Honorables were spouting. "It won't work" said many. "We don't understand what the problem really is." How sad to utter either of those comments!
What has happened isn't complicated. Too many people acquired mortgages on terms they could not afford. The lenders were too lenient, too eager to make the deal, and so too many people got housing they could not afford for very long. When the mortgage rates began to adjust from the very low initial rates, people started to default and go bankrupt at rates far higher than anyone was prepared for. (Lenders always reserve something for unperforming loans.) At the same time, because of both deregulation and lack of regulation of the credit markets, the big banks began to repackage mortgages into sellable securities. It worked like this:
Say that Raphael, Uriel, Michael, and Gabriel each have taken out a mortgage so each can buy a fluffy cloud in Heavenly Hills. Each owes $100,000 to Medici Bank. Medici may keep or sell the mortgages (really, the right to collect the mortgage payments) at any time. Companies like Fannie and Freddie would buy the mortgages and take loan off the books of Medici so Medici could turn around and make some more loans. Remember that loans and credit are what make the modern economy run. But say that Medici combines the 4 loans into one thing called Mortgage A, and sells shares of Mortgage A to spread the risk around. People (institutions, in reality) could perhaps buy a $5000 share of Mortgage A. So far so good. But when the defaults rise higher than anticipated, then the pieces-parts of Mortgage A now become less valuable. Investors began to lose money on these securities, and because they are very complicated, it was hard to tell for a long time what would happen. There are trillions of dollars of these mortgage-backed securities floating around. The credit crunch is happening becasue the securities have dropped in value, and so institutions have to hold more cash to back them and cover the losses stemming from the underlying mortgage failures. If everyone is holding cash to cover their losses, there is less cash available to loan out. Modern everyday commerce depends on loans both long and short-term, and even California is having to ask the US Treasury to lend it money because California can't borrow when no one else will lend.
As I understand it, merely bursting the housing bubble (which is what is happening now) wouldn't necessarily be enough to cause the credit crunch, because the "normal" regulations and safeguards would have been in place to ensure banks had the reserves needed to cover their losses. But when you add in the unregulated securitization of the mortgages themselves, all bets were off. And that's what has happend. It's like a clogged water pipe - the water can't run and shuts everythineg down because it's clogged with bad mortgages and their securities. Loanable money is the water and it isn't flowing anywhere, because everyone is sitting on it to cover their bad loans.
So how to solve it? Remove the blockages in the pipes that carry the loand throughout the economy. In other words, buy the bad mortgages at reduced prices, which clears out the pipes by taking the bad loans off the books of the banks and institutions. Now the water can flow again becauase lenders and borrowers don't have all that bad debt blocking the pipes.
And that's what the bailout plan does. It authorizes the Government to use public debt to buy the debts that are clogging the economic system so that credit and loaning can resume. There are safeguards to make sure that we the taxpapers can recover the sales prices when the firms we buy the debt from recover. But the essense of the plan is to unblock the pipes by getting the bad debt out of the way.
I don't know if the above helps. It's almost more for me than for anyone else, but I hope it helps explain what, more-or-less, is going on and why the bailout was done the way it was done.
The New York Times is doing an excellent job of explaining things, far better than I can. Check it out if you'd care to.