First the simple stuff that you hopefully already know. Stocks are sold by companies to raise capital. The investor gets a share of the company in return and if things work out, dividends from a profitable company. If an investor doesn't care for the company any more or just wants to convert his holding to cash he can sell the stock to someone else. The stock is paper (or used to be, anyway) but the company is real. Land, buildings, equipment - stuff you can see. If stocks are overvalued, then they're worth more than the stuff backing them up. This is the bubble (non-real perceived value) that bursts (people catch on to the perceived value not being real, want to turn their bit real before it goes *poof*) in a correction (the perceived value drops back to the real value). This, roughly, is what happened in the late 1990s when many shaky internet startups were seen for what they really were.
That's not what is going on now. This is more complicated and I'm not at all sure I really understand it. It's a combination of things, of course. Underregulated or incorrectly regulated financial institutions, shaky mortgages, speculation, and maybe even an accounting rule that is having a more painful effect than expected.
It's easy to blame just about everyone in Congress. I've seen folks saying this started with the deregulation of the 1980s and claiming the Republicans are to blame. Fairly recently there was a vote in 2005 about giving a regulator that would oversee Fannie Mae and Freddie Mac real power to put a stop to bad practice and every Republican voted for it, and every Democrat against it - that includes the Dodd, Frank, and Reid fellows who have been asking how did this lack of oversight happen. They really ought to know. However, there is plenty of blame to go around. That's just the recent history. If you really want to, you can probably chase a few threads of this to at least the Carter administration if not earlier.
For the last couple decades the money supply has been fairly closely regulated and the balance of inflation and interest rates, along with other factors, has worked out. A few years ago former Chairman of the Federal Reserve Paul Volker was asked how he'd handle today's (that was the today of a few years ago, mind you) problems and pretty much laughed as the "bad" numbers of that today would have been miraculous when he had the job, and certainly when he started. The result has been fairly low inflation, astonishingly low interest rates, and fairly low unemployment even if that number doesn't indicate what it seems to. There's nothing truly bad, by itself, there.
The low interest rates encouraged borrowing, which is what they were supposed to do. The problem is that not all of the borrowing (and therefore not all of the lending) was sound. A lot of people took on a lot of debt that they couldn't service (make the payments on) when the economy so much as hiccoughed. Some wasn't even that good and was based on the hope of being able to make it work later. That plenty bad, Kemosabe, but it get worse.
The big mortgage institutions of Fannie Mae and Freddie Mac didn't have proper oversight. Whether this is from simple lack of any oversight or from too many overseers to answer to with each assuming the others were taking care of things can be argued, but the result is the same: they did a lot of shaky lending. The 2005 vote mentioned earlier came and went and a deal was struck - they'd see what they could do to provide even more low income housing. It felt good, sure, but the end result was not more sound but even less sound lending. While Fannie & Freddie may be technically private corporations, they are governmental anyway. Just like the post office (work for the post office, you get a federal paycheck... after taking an oath to uphold and defend the Constitution) is a private business that's not really separate. That shakier lending was worse, but we're far from done.
With the two whales of mortgage lending making those loans, the smaller fry followed suit in order to be competitive. Maybe not every fish in the sea, but enough. They also made shaky loans, since if nothing else they could probably pass the loans along to Fannie & Freddie. Now that's even worse still, but we're still not close to being done.
A lender can take out what is basically an insurance policy on the loan. It's a sort of bet that the loan will fail and if it does, they get paid off. This is good for the lender, but a loss for the insurer. The insurer deals with the risk by spreading it out. After all, what are the chances of everything going to pot all at once? You can see the problem here, and yes it's happened or is happening but even that isn't the whole story. Because, so far, the property is still real. The land is still there and any property on it is still there, and the mortgage lenders loss is limited. Values can go down, but real estate isn't known for dropping through zero value. "Buy land. They're not making any more of it."
Those mortgage insurance policies? The ones that were a sort of bet that things would fail? They're not regulated. At all. Which means it wasn't just the lenders making the bets to cover their own risks. It was speculators who figured they could get paid when things failed. A lot of speculators or at least a lot of speculation. Now, there is nothing backing this bet. The shaky loans have started failing in enough number to get noticed and the insurers can't pay off everyone because they simply can't cover every bet made - all the same way. This is the Big Problem. And now we're being asked to bail out... not just the mortgage borrowers (which would get some objection - they ought to have known better - but not all that much).. not just the mortgage lenders (more objection, they really ought to have known better) but the incompetent bookies (no pity for them) and the gamblers trying to collect (less than no pity for them) from the bozotic bookies. The gotcha is that this affects the money supply, and thus the whole economy, whether we want it to or not and whether it should or not.
There is an accounting rule that has come up, FAS 157 the "Mark to Market" rule. This rule says that in trading the insurance policies (bets) that they can only be exchanged at the value they could be sold for. "It's only worth what you can get for it right now." It makes sense, and not too long ago it was embraced as it let companies mark the value up. Now they have to mark it down. Far down. No one want to buy the things. So the system is wedged as they can't sell them, can't afford to sell them, and can't afford not to sell them, and they claim they have to sell them. Or at least that this why the losses are so big. Some claim that the real losses might be only 15% but the perceived losses run to 50% and that that's a big part of the problem - undervaluation. They say that removing or suspending FAS 157 would get things moving again... though I'm not sure how. If there's no perceived value, putting a higher price tag on the thing won't make it sell any faster. Some have called not using FAS 157 allowing "Mark to Make Believe." Is it worth a try? I don't know. I've seen someone claim that doing that would cost $40 billion, which ain't chicken feed but it beats a $700 billion cost... if it works.
"Too Big To Fail"
We've all heard this a few times and it's tempting to disallow anything from getting so big that the country can't afford its failure. The problem is that there are many, many things that size and most are doing at least reasonably well. There is the matter of how to judge when something is too big to fail. Chances are that by the time anyone notices, it's already been that size for a considerable time. Also, who would get to decide that and just what would be done about it?
I'm not saying don't investigate or oversee things. AIG (and a bunch of others) ought to be investigated - but if the only alleged "wrongdoing" is stuff that Congress left be legal, then let's not do anything stupid but just fix the real problem and just be done with it. If there was real, illegal wrongdoing then throw the book at them, certainly. The politics of jealousy and vengeance will not help anyone and are almost certain to make things worse.
The AIG loan (which isn't the $700 billion thing) is structured rather like the Chrysler bailout of the 1980s. The Chrysler bailout was a loan and an astonishing governmental involvement in private industry in the Reagan years. Here's the other surprise for many: it worked, and the federal government came out ahead on the whole thing. That's not a guarantee that AIG will work out that well, but it does mean that it isn't just "Here, have a bag of money."
$700,000,000,000 of... what? Or "Here, have a bag of money."
What do we get for that $700 billion? For the average citizen: nothing but tax burden and more national debt. For the federal government, assuming that the bailout gets them the actual mortgages and not just the bad bets, there is a potential for things to pay off. By one estimate, the payoff could be as high as 2 Trillion (yes, with a T) dollars. Sounds good, right? Double the money and use it to well, pay off the original $700 billion debt and pay off more debt besides. Except for one thing: When was the last time the federal government got money and didn't rush to madly spend it? Heck, I'm trying to recall a time when it didn't spend even the rumor of money - which means that by the time any profit is realized, it'll have been long spent. Not only that, but nationalizing a chunk of the markets is if not socialism, close enough to be worrisome. Creeping Socialism is bad enough, we shouldn't help it up so it can march. If you're not sure of that, think about why this line means what it does: I'm from the governement and I'm here to help. The silly "no oversight, review, etc. of anything" bit is also just plain scary. Lack of proper oversight is what caused the mess. Regulations should be no greater than absolutely necessary, but not nonexistant.
One suggestion was to then give the citizens of the country -- the taxpayers, the people who are really paying the $700 billion -- shares of the companies that the money bails out. This is another tempting but wrong thing. This is a redistribution of wealth on a massive scale - another bit of socialism. There might be a way to do this, but it's not to force people to do it. Forcing is bad; Allowing is good.
Set up a corporation (I don't relish the idea of another pseudo-private corporation of the federal government, but it seems a less bad plan than the ones I've been hearing) whose job it is to do the bailout and sell shares in it - those wanting shares of it can buy them. It's a voluntary free-market solution. And if doesn't raise enough? Maybe it's because the market is smart. The thing to watch is: are billionaires interested? If they want in on that deal, there's a probably a good reason for it. If they stay as far away as they can get, there's a reason for that, too. This is not next quarter type investment. This is buy-and-hold stuff as it will take at least a few years to pay off at all. Oh and ideally, add a sunset provision (this will be hard to get right enough that it can't be fudged) so that the new entity goes away when no longer needed - and it doesn't get to create or redefine the need.
Is that the solution? I have no idea. I don't even know if it's even a solution. I expect that I have some details wrong, at the very least, but this is what has happened as I have come to understand it so far.