So, here it is:
Long ago (when interest rates were high), a bank receives deposits from a large number of customers and makes pretty good profit by lending a portion of the deposited money. The bank can also borrow money from the Federal Reserve or from other banks and lend the borrowed money. However, they are required to keep a portion of their money available for withdrawal.
Once they reached the lending limit, they can't lend any more money. They have to wait for more deposits or for the loans to be repaid.
To overcome that hurdle, they, sometimes, sell some of their loans to other lending institutions. (Many of us have experienced it when we borrowed our mortgage from one bank and ended up paying it back to another firm.)
Then, came the sub-prime debacle.
It started with the banks trying to lend mortgages to low income customers. They made two major assumptions about the low-income borrowers and one major assumption about housing market.
1) The customer's income will rise with time. i.e., The interest rate on their mortgage can rise with time; the interest can start below the prime interest rate (the interest rate that the Federal Reserve charges the bank) and climb with time so that the money lost at the beginning of the loan can be recouped later on when the interest rates are higher.
2) When the loans are structured properly, only a small number of the low-income borrowers will default on their loan.
3) The values of the properties will continue to rise so that even if a borrower defaults, the bank can still make a profit from the sale of that property.
So, they issued loans to low-income customers that start at sub-prime interest rates and climb up with time (at reasonable rates). They, then, packaged these loans together and sold them as securities (like bonds) to investment firms. These packages were rated relatively low risk because only a few loans within a package were expected to be defaulted.
Once a package of loans is sold, the bank can use the proceeds to issue more loans.
The banks, failed to do one major thing. They did not disperse loans from the same region of the country into different loan packages so that an entire package of loan does not become worthless when a region of the country becomes economically depressed.
Well, guess what happened. As regions of the country became depressed and many people lost their jobs, whole packages of loans were being defaulted. When whole neighborhoods were being defaulted, the values of these properties took a dive.
Thus, all three assumptions became false because the banks failed to evenly distribute the risk.
At this point, everyone is still trying to determine which packages of loans are complete duds and which packages are healthy securities.
In the mean time, nobody is willing to buy or sell any of these packages. This stalemate resulted in the banks being redundant to issue more loans since they are near their lending limit.
Unfortunately, our economy runs on credit. The farmers borrow money to buy the seeds, fertilizer, etc. to grow their produce and repays the loans when they sell their produce. Manufacturing firms borrows money to produce new products and repays the loans when the products are sold. Oil companies borrow money to explore and drill for oil and gas and repays the loans when the oil and gas are sold.
So when the banks are not able to lend, the wheels of commerce stop turning. When the wheels of commerce stop turning, people loose their jobs.
What is Henry Paulson and Ben Bernanke's plan?
1) Use 700 billion dollars to buy up the loan packages.
2) Weed out the bad loans and dispose of them (foreclosure)
3) When market calms, sell back healthy loan packages.
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