Ok its important to recognise that there are two ways of looking at this crisis. There is the microeconomic component (i.e. what are the core reasons for the actual collapse) and the macroeconomic component (now that the collapse has taken place why has the shit hit the fan?).
I will discuss the microeconomic component first.
Essentially what happened in the united states around 10 years ago, was the mass securitisation of what is referred to as "sub prime mortgages" which essentially means that they are mortgages given to people who in other circumstances might be unable to acquire a loan. The belief was that if you charge these people a higher interest rate and so long as the loan is secured by a solid investment such as property then losses should be minimised and risks mittigated.
But because these loans were securitised (which means that mortgage originators would on-sell them to other financial institutions such as investment banks), there was an inherent agency problem in this process. Mortgage originators could now pass on the risks to other parties. Subsequently there was an adjustment of incentives. Mortgage originators were receiving commissions for loans for which they bore no risk. Subsequently many loans were given to people who were not credit worthy. Investment banks would purchase these securitised sub prime mortgages without a proper knowledge about the risks involved. For a good few years this system worked well because house prices were high and even though there were loan defaults; the property could be easily reposessed and sold. The profits generated by mortgage originators and investment banks made this an addictive practice.
When the US housing market collapsed (a bubble caused in part by the availability of easy credit), these loans were no longer secured by a significant asset to back the loan. Subsequently a loan default would register as a loss to the investmet bank. It did not take long for the whole system to unravel as these dodgy loans were shown to be worth less than their reported value. This caused the demise of some very big investment banks.
In the US sub prime mortgages comprise approximately 15% of the market. In Australia sub prime mortgages are approximately 1-2%. This is why the direct implications on Australia have been less severe than the US and other econonomies. But this leads to the macroeconomic component of the problem.
This is often referred to as a 'financial crisis' and that is exactly what it is. It is a crisis in liquidity (i.e. businesses cannot obtain funds to continue investing and even operate in some cases such as ABC learning centres). Financial markets (and indeed the entire economy) has certain levels of 'confidence'. The sub prime mortgage crisis has lowered investor confidence such that investors are moving to safer investments such as government securities or blue chip stocks. This leads to an increase in the cost of capital (which is why Wayne Swan has conceeded that an expected 50 basis point reduction in the cash rate is unlikely to produce a reduction in mortgage rates).
This is why there has been turmoil on Wall Street and the ASX. Investors have been pulling out of stock markets. The most recent problems have been caused by the fall of Lehman Brothers in the United States which is a large investment bank. Again, investor confidence was hit and sharemarkets plunged. The bailout is aimed at buying a significant portion of these sub prime securities so as to restore some confidence in financial markets. It is a deal completely aimed at restoring confidence. The bailout itself will not restore the losses, but it will allow investors to feel safe when re-entering the market (in the knowledge that something is being done). There is a lot of arguement over whether the government should spend so much money on this. Afterall its essntially recreating another agency problem in itself (i.e. if you invest unwisely it is ok because the govenment will help you out). Nonetheless Australia will only benefit from the move as its not our money being spent, but I wouldn't want my money spent this way if I was an American.
In Australia the government has a plan to spend $4bn to purchase mortgage securities but this is not anologous to the US plan. The US plan involves purchasing dead in the water securities and making a significant loss. Our plan involves the purchase of triple A rated securities mainly providing margain lenders (such as Wizard and Aussie home loans) with the liquidity they need in order to operate and provide competition in the Australian domestic mortgage market. At the moment because of the way these margain lenders operate (by securitising their mortgages much in the same way as the sub prime lenders), they have been unable to issue as many new mortgages as they used to because of the liquidty problems assosciated with this crisis. So the move by the Rudd government is about restoring liquidity into the market to generate competition for the major banks.
