The credit crisis in the simplest terms possible

It's really not about the stock market and only indirectly about bad mortgages. What it is really about is credit default swaps. Here, as I understand it is the problem:

Banks for whatever reason issued a lot of sub-prime mortgages. Some of it because of the requirements of the Community Reinvestment Act, some because of easy credit, and some because of simple greed.

Because those loans were risky the buyers of Mortgage backed securities took out credit default swaps (CDS) against them.

The CDS was originally designed as a kind of insurance but grew beyond it's purpose and people began using them to, in an essence, short securities. Hedge funds also began to buy CDSs at one price against a comapny and then sell them at another price to a counterparty.

None of this was regulated so there is no transparency into who holds what.

The Fed does know that there are $60 trillion (60,000,000,000,000) in CDSs held again $5 trillion in mortgage backed securities.

This is why the credit market is freezing up. Banks are unwilling to lend to other banks because they don't know there exposure via CDSs to a potential failure.

From what I understand it will only take one or two banks not meeting their requirements under a CDS contract to set off a chain reaction failure among banks. No one wants to take on that exposure.

That is why, I think, the government is going to buy mortgage backed securities. To inject faith into the market that the securities won't fail and to open up lending between banks again. Once that happens they can start sorting out who holds what as far as CDSs go and start regulating their purchase like the SEC wanted to a few years ago.

Even then this is likely to be a real mess. From what I understand there are really only 5 or 6 people who fully understand how these things work. They are the people who designed the models that decided using these instruments in this way was a good idea.

I know that there has been a lot of talk about the subprime mortgage bubble being the cause of this mess, and that's true in that it's failure was the trigger, but it was really the leveraging of Credit Default Swaps that is delivering the killer blow.

Today's New York Times has a pretty good article on how Fannie Mae and Freddie Mac got caught up in the whole sub-prime mess, although the try and shield a lot of people from blame, such as Barney Franks, who really need to be handed their head.