In one comment on another blog, someone asked "So, tell me how repealing that stupid law created loans to people who could not afford it", referring to the refusal to regulate Fannie and Freddie away from risky loans.

The loans people could not afford were created this way.  FB & FB offered "no doc", "low doc", and Stated-Income mortgages to people who had high credit scores.  In fact, I have a stated income loan myself that initiated 3 years ago.

Conventional mortgages require you to submit tax return and financial statements, proving your income, so that brokers could decide the risk level of loaning you the money you're asking for.  Furthermore, you would typically be required to put 20% of the value down in cash.  Due to Democratic legislation, mostly during the Clinton years, these restrictions were greatly loosened, and there were products made available to the market such as 100% Loan-To-Value (LTV), meaning you didn't have to put anything down whatsoever, Stated-Income loans, meaning your income would not be verified, No-Doc and Low-Doc loans, meaning you would not be required to submit tax returns or other proof of income - sometimes not even proof of employment.  These products were more scarce at their onset, because institutions knew they were risky, but as the housing market began to rise with the influx of investor money more and more of these products came available and were easier and easier to get.  Seriously, all you needed was a 720 credit score and you could ask for, and qualify for, a No-Doc Stated-Income 100% LTV mortgage.

So here's how does that create a crisis?  Go back 4 years and consider a very common scenario.  A house that was worth $125K 2 years ago is now worth $265K.  You're thinking of selling and upgrading, but your income level wouldn't permit you to buy a $325,000 house.  You had a strong credit score, so you could just do "stated income", stating that you make $250,000 a year whether you do or not.  Then, you take a 3/1 ARM starting interest only for the first five years, because you COULD afford the interest-only payment, $1,700 a month for the first 3 years.  After that, it would convert to an ARM & you'd start paying principal.  But you're thinking, this house was worth $200K a year ago & it's worth $325K now, so in 3 years it'll probably be worth $5 or $600K or even more.  If I can't make the $2,700 payment when the loan converts I'll just sell it & pocket the profit.  Well, foreclosures started, loans got harder to get, so values started dropping, and now that house is only worth $200K.  You can't afford the big payment, and you can't sell to get out of your loan, so you're stuck... you struggle along for a year or so, hoping things will turn around, but you start missing payments and soon you're in foreclosure with no other options.  The bank can't even do a short sale because after closing they'll only get $190K or so on their $320K investment.  You entered a risky venture and it didn't pay off in the end; it goes that way sometimes.

Multiply that scenario by several hundred thousand because now you're in the same boat with up to 5% of the nation's home-owning population, and that risky move is now causing the paper that guarantees those loans to loose value.  When the brokers can't sell the paper, they can't raise cash to start new loans, so they become insolvent.  That's where we are now - your risky loan was sold to a clearing house, but now the market doesn't want your paper because of the risk, so the money stops moving.

So now enter what we're calling the "bail out".  Actually, I wouldn't even call it a "bail out" so much as an "investment".  We're not handing a blank check to failed banks to make them solvent again... not at all, actually.  The idea is to reserve as much as $700B to buy the paper on those loans & get some cash back into the system.  Then, once the market re-stabilizes, the paper can be sold back into the market, most likely for a profit.  So the Fed becomes the holder of the paper on your loans.

See, it's really not that complicated... take a look at a $265,000 mortgage.  The bank bought your loan, and passed the money to the entity from whom you bought your house.  You enter a contract with the lender for, say, $1,700 a month for the next 30 years.  The total sum of payments after those 30 years will be $612,000 (add all the payments together - 30years X 12 months X 1700/month).  So, the value of that "Paper" (your loan) to the bank is $612,000.  Well, that's a fairly long-term until they get a total return-on-investment, and they need more cash to keep handing out new loans.  So, they sell the paper on your loan to another house for $400,00 - giving them back the $265K they invested in your house plus a $135K gain.  Then, your monthly payments now go directly through to the new entity.  Well, the fund that bought the paper for $400K might need more cash to do the same kind of thing again, so they might sell that $612K worth of paper to another entity for $450K, making a $50K profit.  And on and on. 

But now we're in a quandry because the foreclosure rate has the fund-holders and the market nervous, so they're not so willing to buy the paper anymore.  That trickles right down to the banks, and the cash stops moving, so eventually the banks have no more cash to hand out in new mortgages.  They sold most of their paper, so they also don't have enough monthly cash coming in to cover their operation.  Now they have to cut back, and some disappear.

Making some sense?