How it came to this

It's been headline news for weeks now, but for many of us, our country's economic crisis is still extremely confusing. Why are we in such a bad situation? What's happening over on Wall Street? How did we even get to this point in the first place? The answers aren't simple and there's no quick fix, but one thing is for certain: Everyone has a role to play.

Before we begin: A bit about confidence

Our economy relies on confidence. Banks will only lend money out if they are confident that they will get it back. Citizens only invest when they are confident that the market is doing well.

Confidence is what allows many Americans to purchase a home. Instead of paying hundreds of thousands of dollars at once, homebuyers go to the banks, which lend them the money they need to buy the property they want (this is called a loan). The homebuyers agree to give the banks a small amount up front (a down payment) and pay the rest back over a longer period of time (usually about 30 years).

Now, this is all well and good for the borrower, but what about the banks? If the borrower can't pay back all the money they've taken, then the banks are out a hefty sum. To prevent this, the borrowers are required to pledge the property to the banks as a security, better known as a mortgage. If the borrowers cannot pay up, then the bank forecloses on them, inheriting the property.

So if worst comes to worst, the banks foreclose on the home - the deal ends, and now the banks own the property. As long as the house is as valuable as it was at the beginning of the process, the banks don't lose anything and can continue to lend out money to other borrowers. The banks are confident that the borrowers will be able to pay back the loan. And if the borrowers can't, the banks are confident that the property they purchased will still retain its value.

As we will soon see, some of that confidence was misguided.

Phase one: The bubble takes shape, and Wall Street takes notice

Let's turn the clock back a few years. It's the '90s, and houses have become more than just places to live. They are investments. You can buy them cheap and then "flip" (or sell) them for overnight profit.

Prospective homeowners can buy a house for 10 percent down or less. Interest rates on mortgages are historically low at less than five percent. Some people opt out for Adjustable Rate Mortgages that can guarantee an even lower rate - albeit one that rises after five years. The market is growing. Homeowners see the value of their homes skyrocket as a result of high demand, and banks and sellers reap huge profits.

Meanwhile, on Wall Street, the big investment firms are looking for new ways to expand America's pool of money. It's not going to be through their former investment of choice, the safe U.S. treasury bonds, as former Federal Reserve Chairman Alan Greenspan is keeping the interest rate at a frustratingly low one percent. But what about the housing market? Homeowners pay a juicy five, six, seven, or eight percent as interest to banks - much better for lenders than the interest on treasury bonds.

Wall Street firms decide that they want in on the housing market action, so they devise a plan - a way to get some profit from individual people's mortgages without the hassle of dealing with individual people.

It works like this: A prospective homeowner gets a mortgage from a broker, who sells the mortgage to a small bank. A Wall Street investment firm then buys a bunch of these mortgages from a bunch of small banks, giving the firm a large monthly stream of money over the next 30 years (the life of a mortgage). The firm then sells shares of this income - called "mortgage-backed securities" - to investors. Everyone profits so long as people pay off their mortgages. The American home is now an American investment, a seemingly secure market that has (for the most part) always gone up in value.

BOTTOM LINE: Small banks sold individual people's mortgages to Wall Street.

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Before long, the frenzy begins to slow down. By 2003, nearly everyone who wanted a mortgage - and met the qualifications - has gotten a mortgage, meaning there are no new investments to sell. But no one wants this to come to an end, not with all this profit to be made. So the banks change the rules.

If everyone who qualifies for a mortgage already has one, and you want to keep selling mortgages, then the only thing left to do is lower the qualifications. Banks begin to lend money to people who never would have qualified before - people without a stable income or sufficient money in the bank. The guidelines for obtaining a mortgage get looser and looser, as a series of new loans are developed.

The banks stop checking up on the salaries of their customers, essentially taking what they say at face value - a policy that encourages borrowers to lie about what they make. To qualify for some loans, customers don't even have to say what they do for a living, or explain their source of income. The banks seem to be giving their money to (and putting their confidence in) aspiring homeowners who may not deserve it.

All of this raises an obvious question: Don't any of these banks see the risk of making loans with such loose and sloppy guidelines? Well, they may - but unlike the old days, they don't have to worry about the borrowers paying them back. The small banks no longer need to have confidence in the borrowers; they hold on to these mortgages for a few months at the most and then sell them to major Wall Street investment firms. Everyone is fine, so long as the housing market keeps going up.

BOTTOM LINE: Banks lent money to people who couldn't pay it back.

Phase three: The tipping point

In 2007, the housing market stops going up. With the number of homes for sale decreasing, housing prices stall - they don't go down, but they don't go up, either. And as the country loses that all-important confidence in the market, people panic.

Homeowners fear that they'll lose the profit they expected to make as housing prices rose, thinking that they could earn some money by buying low and selling high. Some try to sell before prices hit the floor.

The market is filled with supply and devoid of demand, and as a result, housing prices begin to plummet. The lack of demand prevents many who want to sell their houses from doing so. But many of these people also cannot afford the interest rates that have jumped as part of their Adjustable Rate Mortgages (remember those from phase 1?). The bubble has finally burst.

BOTTOM LINE: Houses lost value, people panicked.

Phase four: We all fall down

As banks demand that everyone pays up, millions of Americans are faced with the prospect of losing their only home. Foreclosures begin. Wall Street realizes that all the packages of mortgages they've bought are now completely worthless because they can never be paid off. Three of the nation's top five investment banks, AIG, Lehman Brothers and Merrill Lynch, plus the government-sponsored enterprises Fannie Mae and Freddie Mac, either collapse or are taken over.

Fannie and Freddie stop buying mortgages. Banks cease making loans to both customers and other banks. There is a credit freeze - money isn't moving around any more, at least not in the upper levels of the American economy. Confidence is at an all-time low. Some financial trouble spreads to Europe. And now, there is talk of the crisis as the worst of its kind since the Great Depression.

So that's how it came to this. Where does the blame fall? On the homeowners who bought more than they could pay for, some of them lying about their income? On the small banks, which sold unsecured mortgages to some unsuspecting homebuyers, home buyers who are now facing foreclosure? Perhaps the blame falls on the Wall Street investment firms who bought the now worthless mortgages, and, in a sense, were pulling all the strings through the duration of the bubble?

It's not clear, and frankly, it seems like everyone may have a stake in the blame. We may not find ourselves in a global economic depression, but it's quite possible that our economy will be in a sad state for some time to come. Congress is developing a massive bailout plan to begin healing the crisis. As for the rest of us, the only thing we can do is wait it out. But still, it's good to know how it all went down.

BOTTOM LINE: Since homeowners couldn't pay off their mortgage loans, the mortgages that Wall Street spent millions of dollars on are now completely worthless.

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