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The current crises in out economy was difficult for me to understand, but I have spent some time researching the situation and have a perspective. I believe that the real culprits are the financial companies. The process is very complicated but I will try to explain. 

1. The problem did not start with the sub-prime mortgage loans. It started in 1996 when J P Morgan conducted a strategy retreat for its employees. 

J P Morgan was cash strapped. Their books were loaded with billions of dollars in loans to corporations and foreign governments. Federal law required that they keep huge amounts of capital in reserve in case any of the loans went into default. That reserve capital was not available for other operations which lessened their ability to make more money.

During the brainstorming sessions a new idea surfaced. Why not attempt to guarantee the loans using a third party? So they devised a program resembling an insurance policy. A separate company would guarantee the loans in exchange for a regular payment, like an insurance premium. With the loans secured J P Morgan could utilize the “reserve” funds for other investments. They named this strategy “credit default swaps” (CDS).

These CDS plans grew massively over the years. Many other businesses adopted the strategy. According to Janet Morrissey of Time Magazine CDS grew to 45 trillion dollars by mid 2007. And according to Michael Panzer of seekingalpha.com, world wide derivatives grew to 681 trillion dollars.

With the CDS concept, increasingly the monetary worth of Investment institutions, like AIG and Bear Stearns, was on paper instead of property or actual capital. So when an insured company failed, the financial corporation was short of cash. If the failing company was very large, or if several businesses failed, the insuring establishment did not have the assets to meet their obligations. CDS led directly to the AIG bailout.

2. Then comes the sub prime loans to marginal credit customers. With money to invest, financial institutions needed an outlet, so they turned to real estate. They devised new loans, which like CDS, were inventive. The mortgage companies noticed the home prices continued to increase over time. A homeowner could buy a house and several years later it could be worth twenty percent more, providing the owner with equity. They also noticed that people traded homes every three or four years. In the image of CDS, they decided that if they loaned 100 percent of the assessed value on a home loan and kept the initial payment low, people who usually could not purchase a home would do so. Since the homeowner would be moving or refinancing in a few years, they could make the loan palatable to major investors (the CDS insurers) if the interest rate would increase after the first three years. Since the house would be worth more, everyone wins, and if the mortgage holder defaults, the company makes a profit from the increase in value.

When homeowners were unable to refinance, experienced difficulty making the increased monthly fees, and got behind in their payments, mortgage companies decided to foreclose and get the equity increase for themselves. But the result was too many homes on the market. So home prices went down instead of up and everyone lost. Many mortgage companies looked to their CDS insurer who defaulted in their guarantee, so the mortgage company went bankrupt because of their actions.

3. Essentially the current problem is a lack of credit. As a result of CDS, with so many corporations vulnerable, lenders are nervous and reluctant to lend money to corporations. Many financial institutions are short on capital and unable to do business. Since even healthy corporations are unable to get loans to finance their operations, a panic has ensued. How do investors trust corporations again when they have demonstrated their lack of responsibility.

Some Sources:  Janet Morrissey, Time.com March 17, 2008:  Dr. Ellen Brown, Global Research.ca, April 11, 2008;  Engdahl, editorial, financialsense.com, 06062008;  AP report, Business Week, October 8,2008.  Investopedia.com, seekingalpha.com.