Risk and return, fear and greed. These are what makes the capital markets work. Greed is the motivator, fear is the regulator. Greed is constant (people always take as much as they can get), fear is variable. Greed is slow, fear is quick. Markets may go down 2% in a day, but they don't go up that much ever.
For the markets to work efficiently, greed and fear must be balanced. Too much greed (or too little fear) creates a bubble, too much fear creates a crash. Most of the time, markets are self-balancing. Too much or too little fear or greed creates an opportunity. Traders exploiting that opportunity eliminate the imbalance. Nevertheless, after 1929, everyone agreed that government regulation was necessary to keep markets honest. Without honesty, inefficiencies can be created that benefit the creators at the expense of everyone else. The market can be deprived of the opportunity to self-balance.
A lack of regulation during the Bush administration has led directly to the present market turmoil. And make no mistake, this is a market problem that impacts the economy, not an economic problem impacting the markets. The key issues are actually quite simple. The capital markets are a huge money rental operation. People with money rent it to people who need it. The interest is the rental fee. All other things being equal, the interest rate rises as the risk of default increases. The safest investment is government bonds. The government never defaults. They can always raise taxes or print money to pay back lenders. Corporate bonds are, by definition, not as secure even though corporations rarely default. Interest rates are therefore higher for corporate bonds. Because bonds are negotiable, there is a secondary market. I can buy a government bond, and resell it to someone else. That liquidity is the lubricant needed to balance fear and greed.
The problem for capital markets is that government and corporate lending are together less than consumer lending. If you have money to lend, and we all do via mutual or pension funds, then you need to find ways to lend it to consumers. But consumer credit is too risky and too regulated to package effectively outside banks. Mortgages are different. They have very low risk since almost nobody defaults on their house payments, and if they do, the lender gets the house. As a result, overall risk for mortgages is in the corporate bond range. Unfortunately, laws in most countries ensure no secondary market for mortgages. After US laws were losened in 1999, Wall Street firms have figured out how to create a secondary market. A Wall Street bank would buy a packages of mortgages from several banks. Because the packages were from different lenders in different parts of the country, the overall risk was low. The Wall Street bank would then turn the package into bonds. It could then sell the bonds on the open market. Everyone loved it because it was a great idea.
Banks loved it because by law, they can only lend out so many dollars for each dollar on deposit (their reserves). Selling a package of mortgages took them out of the "lent out" category. The people buying the bonds loved it because it was a way for mutual and pension funds to get into the low-risk mortage market without buying a bank. But most of all, the Wall Street firms loved it because they made their money on fees. They didn't have to lend anyone anything, they just collected a fee for packaging and re-selling the loans. No risk, just returns. Even if they only made pennies on each thousand dollars of bonds they processed, it was fantastic. The consumer mortage market is huge, and Wall Street had just figured out how to route that Niagara through their firms.
The whole thing started out well. But there was a fundamental divorce of risk and return. Those lending the money to consumers were selling the loans, so they didn't have to worry about getting paid back. Those packaging the loans were also passing the loans along, they didn't need to worry either. Those buying the loans or mortgage-backed securities as they were called, had no idea where the loans came from. They just expected them to be as risky as most mortgages, not very. Soon enough, unscrupulous lenders started lending mortgage money to anyone who asked for it, then hid the dodgy loans in a pile of good loans and sold the whole thing to a Wall Street bank. The Wall Street people didn't look at the loans too closely as fussy detail would slow down that volume. Consumers came to believe house prices would always to up at increasing rates and that by re-mortgaging, they could take a cut of that value for themselves. Fear had been eliminated from the equation.
All this was bad, but not fatal. Then, the banks crossed a line. The banks that had made and sold the loans started buying the mortgage backed securities of other banks. Since these were negotiable securities, they were added to the banks reserves. By securitizing mortgages, they had figured out a way to turn a $1 of lending into a $1 of reserve. All the US banks went on a spree of buying each others securitized mortgages, thereby allowing themselves to lend even more money. As long as housing prices kept rising quickly, nobody had to notice, and the government was no longer paying attention. But like all bubbles, the US housing bubble burst. Housing prices dropped and people started walking away from their mortgages. Historically, default rates on mortgages have been 2% or less. Many batches of securitized mortgages are now defaulting at a rate of 10%. Some of the worst batches are approaching a 30% default rate. Now the banks have to notice. Because housing prices have fallen, they can't recoup defaults easily, quickly or at 100% of the value of the bad loans. Their precious assets that govern how much money they can lend are suddenly questionable. They either have to raise more money to compensate for the bad assets, or they have to reduce lending, or both. Those unable to make the adjustment fail.
So far, only those banks and trusts with the biggest exposure to mortgages have failed. But nobody knows how deep the rot will go. How many mortgages issued in the last 10 years are worthless? Nobody knows. How much will the banks lose on those bad mortgages? Nobody knows. Have the bad loans seeped into other consumer and business lending? Nobody knows. How many more banks will become insolvent? Nobody knows. Uncertainty = risk = fear. Fear, so long banished from the capital markets, now rules all the financial markets. The real problem now is that international investors may decide to take their losses and dump US dollar assets. That could create a ruinous run on the dollar. Ruinous for Americans, but bad for everyone in lesser degrees depending on how much they trade with the US. Poland should be ok, Canada will get hit hard. The party is over, and the hangover may prove fatal.
Update: Edits to remove half-assed explanation of how securitization works. See part 2 for a simple explanation of this. Also swapped graphics with part 2.