I made the following as simple and concise a summary of the economic crisis as I could for my friends, and figured I'd share it with my friends on daily kos as well. The core of it came from Devilstower's post, but the rest from the sources at the bottom or conversations with economists. I hope it's useful.
The following is a summary:
The Gramm-Leach-Bliley Act (1999) repeals the Glass-Steagall Act, removing banking regulations that have been in place since The Great Depression. This accomplishes two things: allows banks to merge and consolidate into much larger institutions; allows commercial banks to invest money in other assets (like stocks, or "credit default swaps") with looser reserve requirements.
A note about banks: Commercial banks are in the business of taking money from depositors (when I deposit money in my checking account) and lending money to debtors (when I take out a car loan). Now they can also spend their money buying stocks. If the asset value of a bank ever falls below the value of depositor accounts, it is bankrupt (doesn't have enough money to pay people back). That's why it's risky for banks to start buying things (like stocks) that have a fluctuating market value.
Under Glass-Steagall, commercial banks were usually levered about 5:1 (meaning they had $1 cash for every $5 in debt assets like loans). With the repeal of Glass-Steagall, these banks get levered as high as 30:1 (Lehman Brothers) or 40:1 (Merrill Lynch). That makes them very vulnerable to loan defaults or market decline.
The Credit Default Swap (CDS) is invented. A CDS is essentially an insurance policy on a loan (for example, mortgages or bonds). If Bank A wants to give me a mortgage but I have poor credit, they can get Bank B to offer a CDS so that if I default, Bank B pays the remainder of my debt. The CDS is poorly understood, and so the Bank Bs of the world treat it as a source of revenue (Bank A is paying them for the insurance) without fully understanding the risk associated (they have to pay up if I default, and they don't know how big of a credit risk I am).
The Commodity Futures Modernization Act deregulates many risky investments, but most importantly for the current crisis it sheltered CDS from regulatory oversight.
Banks begin to merge and consolidate into much larger institutions (too big to fail) and begin to get more heavily involved in trading stocks, bonds, and (most importantly) CDSs. To continue the above example, Bank C might notice that Bank B is making quite a bit of money off my CDS, and so they offer to buy it. Because of poor regulation and transparency, they have no idea about the downstream risk (that I might default), all they know is they get paid for holding the CDS.
A speculative market in CDS trading emerges due to lack of regulation and oversight (compare to the stock market just before the Great Depression). People start bidding up the price of CDSs to the point that their price no longer reflects revenue potential (much less associated risk). For a sense of proportion in values circa 2007: entire US Treasury Market is $4.5 trillion, entire mortgage market is $7 trillion, entire U.S. stock market is $22 trillion, entire CDS market is $45 trillion. CDS trading is a global business, not restricted to the US.
People start defaulting on their mortgages, and for the first time institutions that own CDSs realize what a liability they are now that they are called in to pay.
CDS trading grinds to a halt because banks realize they are not just over-valued, they are POTENTIAL DEBT! No one wants to buy or sell CDSs, realizing what a gamble they are. Everyone sits tight and prays nothing bad will happen.
More Americans default on their mortgages. Bear Stearns, Lehman Brothers, AIG are the first major lending institutions to go bankrupt paying off CDS obligations, but everyone on Wall St knows this infection has spread to the entire global system.
Everyone freaks out and credit comes close to freezing. Banks become afraid to give loans because they have so little cash on hand. They are afraid that they will be called to pay on CDS obligations due to defaults. Moreover, because the market has slowed, they can't sell their assets (particularly CDS assets) to GET cash. A CREDIT FREEZE IS THE WORSE THING THAT COULD HAPPEN TO THE ECONOMY! Imagine having to buy a house without a bank loan. Every major business transaction requires loans. If businesses can't get loans, they can't do business.
The current plan (Paulson Plan) is for the Federal Govt to spend all of it's remaining treasuries and issue more ($700 billion worth) buying bad CDS-related debt in the hopes that they can restore confidence in the system by removing some of the bad debt and giving banks back some cash. This is a short-term solution, designed only to give banks enough money to continue making loans to businesses and keep business functioning. Banks are still at risk of going bankrupt if their remaining assets devalue or more people default on loans. If the Paulson Plan doesn't work however (which doesn't seem likely to me), it will only waste what few resources the federal govt has left. The govt will then have no choice but to begin printing more money, which will create massive inflation and cause the global economy to go into a downward spiral.
Note that because banks have such small reserves of cash, they are much more vulnerable to bank runs. Anyone who has an account will get their money back eventually (because it is federally insured), but the Fed might have to print more money to provide it all, with the above effect of inflation.
Why is no one talking about George Soros's far superior alternative to the Paulson Plan? Seriously, contact your member of Congress about it.
Below are some useful related resources:
[1] IMF study of 42 systemic banking crisis worldwide and how they were resolved. Note: only 7 of them were resolved through purchase of toxic assets, and that was usually the most expensive and pro-bank solution.
[2] Great NPR discussion of our brush with a credit freeze and why this would have been catastrophic.
[3] Blog post on the Fed's response to this crisis:
[4] Blog post explaining CDSs.