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The roots of the crisis lie, ironically, in the housing boom of the late 1990s and the early years of this decade. A strong economy and low interest rates meant that it was much easier for people to get mortgages to buy homes. The problem is, a lot of people who bought real estate probably shouldn't have—including investors who thought prices would keep going up and they'd be able to sell at a profit, and first-time home buyers who couldn't really afford their mortgages. At the same time, mortgage lenders lowered their standards, granting loans that they probably shouldn't have made.
It was all fine until two years ago when the housing bubble began to lose air and real estate prices started falling. That made it harder to sell a house, and for the millions of people with adjustable-rate mortgages whose monthly payments went up, it became harder to keep up the payments on the houses they owned. Foreclosures began rising.
Housing booms and busts are nothing new. Why did this turn into something much bigger?
What's different is the way banks handle mortgages today.
It used to be that a bank gave you a mortgage for a house, and every month you paid a little bit back, with interest, for 30 years, until it was all paid off.
In recent years, banks found it more profitable to take thousands of mortgages and bundle them together into something called "mortgage-backed securities" that can be sold and traded—like a stock or bond—to other financial institutions. That explains why when your parents pay their mortgage, they may write the check to several different entities over the years—to whoever "owns" the mortgage at the time—even though you're still in the same house.
When homeowners began defaulting and foreclosures rose, these mortgage-backed securities were suddenly worth a lot less. What made it scarier was that no one seemed to know how much less, because these investments were so new and complex.
If you can't figure out what something is worth, no one will buy it, and that's exactly what happened: The market for these "toxic securities" simply dried up, Wall Street panicked, the stock market tumbled, and some of the banks and financial institutions that owned these securities went bankrupt or were taken over by the government.
So a lot of bankers are hurting. But what does that have to do with everyone else?
Whether it's fair or not, when Wall Street suffers, so does the entire economy. Plunging stock prices mean millions of Americans who own stock—either directly or indirectly through a retirement plan—have less money to spend now, or later when they retire.
Making matters worse, banks with these troubled securities went into lock-down mode, causing a credit crunch: They stopped lending, not just to big companies, but to ordinary folks trying to get mortgages, credit cards, student loans, or money to run their small businesses.
Why did Washington feel it had to come up with a big rescue plan?
The piecemeal approach—dealing on a case-by-case basis with troubled companies and either bailing them out or letting them go bankrupt—clearly wasn't doing anything to address the bigger problem of a lack of confidence in the system. The stock market kept on tumbling, and credit got even tighter.
What is this $700 billion bailout plan actually supposed to do?
The government plans to buy all these "toxic" mortgage-backed securities so that the banks and financial institutions won't have to deal with them. The hope is that will let them get back to their business of making loans to companies, home buyers, and individuals—and get the wheels of the entire economy moving again. As for the $700 billion number, it is simply an estimate of what the cost will be since no one really knows the true extent of the problem.
But opposition to the bailout has been intense, with lawmakers and their constituents angry about using taxpayer money to help big financial institutions that were making huge profits for so many years. Advocates of the rescue don't like it much either, but say that the alternative is a potentially catastrophic meltdown of the entire economy, with Main Street suffering as much or more than Wall Street. One provision added to the plan in response to the initial outcry is that companies that participate will have to limit executives' pay.
So who picks up the tab for the $700 billion?
While the government will not actually write a check for $700 billion, U.S. taxpayers will end up paying in some form.
In the short run, the plan will swell the federal deficit and force hard choices on the next President and Congress about raising taxes or cutting spending to help pay for it.
Long term, the tab could end up being less than $700 billion: If Washington's response restores confidence in the financial markets—and among consumers—the value of the securities the Treasury is buying could rise, and eventually be sold by the government at a profit. (Of course, it could also end up costing a lot more; no one knows at this point.)
How does the crisis affect you?
The credit crunch is already making it harder, and more expensive, to get loans of all kinds—from car loans and mortgages to credit cards—especially if you don't have a long and rock-solid credit history.
If you or your parents have credit cards, you may already be feeling the pinch: Many card issuers have cut credit limits on cards already out there, and are being much tougher about issuing new ones.
If the economy goes into a severe recession as a result of this turmoil as some economists are predicting, the impact will be felt on Main Street as well as on Wall Street. Unemployment will rise, companies will go out of business, and the housing market could continue to decline. And with companies laying off workers, it could be particularly hard for young people trying to get their first jobs out of school, or part-time and summer jobs while still in school.
Are we headed for another Great Depression?
Most economists don't think that's in the cards. They generally agree that the Depression was caused by a series of bad decisions, or lack of decisions—including the failure of Congress and the Federal Reserve to take action following the stock market crash in October 1929. And many New Deal measures—like deposit insurance on bank accounts and unemployment insurance—are designed to keep recessions from turning into depressions.
"I don't think we'll go into the Great Depression where unemployment was 25 percent," says Martin Baily, an economist at the Brookings Institution. "But we could go into a much more severe recession like we had in the early '80s."
Do we need more regulation?
There's a consensus in Washington that the current system of regulation of the financial markets needs an overhaul.
Some argue that the deregulation of recent years needs to be reversed, with greater government oversight to prevent this from happening again. But there's widespread agreement that a big part of the problem is that our financial regulatory system largely dates back to the Depression/New Deal era, and simply wasn't designed for the way Wall Street and Main Street do business 75 years later.
What do McCain and Obama say about all this?
Both candidates have generally supported the rescue package. Though neither was enthusiastic about it, they both agreed that a broad government response was needed to prevent potentially catastrophic damage to the economy overall. It's sure to remain a big issue—maybe the biggest issue—for the final month of the campaign.
