Best explanation ever from a blog Good Math, Bad Path. I’m reprinting it in its entirety.  The title of the post is Economic Disasters and Stupid Evil People:

With the insanity that’s been going on in the financial world lately, a bunch of people have asked me to post a followup to my earlier posts on the whole mortgage disaster, to try to explain what’s going on lately.

As I keep saying when people ask me things like this, I’m not an economist. I don’t know much about economics, and what little I do know, I tend to find terribly boring. And in this case, the discussion inevitably gets political, so I’m expecting lots of nasty email.

Anyway, with that said, I’ve been doing a lot of reading, to try to understand this mess. And I’ll try to explain what I’ve figured out.

The situation is both very complicated and very simple.

The simple version? People made lots and lots of stupid loans that couldn’t be repaid.

Of course, it’s not really that simple.

The mortgage mess is the starting point. If you recall my posts on the mortgage mess, what happened was:

1. People like buying safe investments.
2. Historically, mortgages are very safe investments: people will go to incredible lengths not to lose their homes.
3. Banks realized that they could make lots of money by taking groups of mortgages, and turning them into bonds that they could sell, earning a commission, and passing the risk to whoever bought the bonds.
4. These bonds became incredibly popular. Lots and lots of people and organizations wanted to buy them.
5. There aren’t enough good mortgages to put together the number of bonds that people wanted to buy.
6. So banks started giving out mortgages to people who couldn’t repay them, using elaborate and dishonest schemes to pretend that they were actually not bad mortgages.
7. The people who got mortgages that they couldn’t repay didn’t repay them.
8. The banks act surprised: "My god, no one could have predicted that so many loans would default! Whine, whinge, moan, someone come help us!

What’s going on now is directly related to that mortgage mess. A good metaphor for it is that the current situation is like a huge city of skyscrapers built on a foundation of sand; the mortgages are the sand.

What we’ve been seeing over the last couple of weeks is the same basic scam as the mortgage mess, but on an even larger scale. Lending money is a profitable business. Bundling loans into investment vehicles is an incredibly profitable business for producing what appear to be high-yield, low-risk investments.

Naturally, when there’s a big opportunity to make lots of money, there’s a ton of people looking to get in on it. Of course, just like with the mortgages, there’s a limit. Realistically, there’s only a certain amount of money that can be loaned at any time to people who can pay it back. But there was so much money to be made that as the high-quality loans ran out, they started looking for other things that they could wrap up as investments. Of course, since people who buy these kinds of investments are typically looking for something really safe, that means that they can’t just give money out any-which-way; they need to have some plausible way of saying "This is really safe".

And here’s where the stupidity really started kicking in.

How do you take a bunch of loans that might not be repaid, and turn them into something that’s safe? Well, what do you do if you had a lot of money tied up in a piece of property that you could lose in an accident? Like, say, a car or a house? You’d buy insurance!

That’s basically what the investment firms did. They gave out shit loans that any sane person should have known couldn’t be repaid, and then they bough insurance on them to guarantee that at least the principal would be safe.

So who did they buy insurance from? Mostly each other.

So they were taking massive numbers of shitty loans that they knew couldn’t ultimately be repaid, and repackaging them as safe investments. They did that by a combination of building up structures like tranching, and by buying insurance. So between the structure and the insurance, they could take these loans to a rating agency, and get them to say "This is a really safe investment".

But it was really all a scam. The insurance didn’t exist; the structure didn’t actually really reduce the risk. Ultimately, the same basic gaggle of businesses that were selling the loans as investments were providing insurance to each other!

So what’s happening now is the natural, expected outcome. Look at this mess: What could possibly go wrong? Let’s work it through. Suppose firm A issues a bunch of crappy loans, and buys insurance for them from firm B, and firm B issues a bunch of crappy loans, and buys its insurance for them from firm A. Now, both A’s crappy loans and B’s crappy loans start to fail at the same time – that is, both discover that substantial numbers of those loans aren’t going to be repaid. Then firm A comes to firm B with an insurance claim requiring B to repay A’s failed loans; likewise, B comes to A with a claim. Both A and B are in deep trouble.

It gets quite a bit stupider when you look at the details of some of these deals. I saw an article about two weeks ago in the New York Times (no links, because articles over a week old go behind a pay wall) that was talking about one loan package issued by UBS. They had one bundle of about 20 billion dollars of loans that they resold as bonds. They bought "insurance" on it from a much smaller investment firm, whose total assets (that is, every bit of money that they had any plausible claim to be able to raise) was 200 million dollars. Think about what that means: the guys insuring those 20 billion dollars of loans had absolutely no way of covering them: the insurer couldn’t possibly ever pay off the loans they were insuring if they failed. But on the paper that got the loans their high-quality rating, it said that they were fully insured. So there’s no way in hell that if those loans failed, the insurers would be able to pay up, and the folks selling the insurance knew it, and the folks buying the insurance knew it. But they just assumed that somehow, this would all work out.

This is really the basic idea of what’s going on right now. Massive numbers of loans were given out that couldn’t be repaid; massive numbers of people and institutions bought investments on the assurance that they were absolutely safe, when in fact they weren’t worth the paper they were printed on.

Of course, simple stupidity is never enough. People need to pile stupidity on stupidity on stupidity. Lots of those loans were what are called leveragedinvestments. That is, suppose I want to invest in fund X. But to buy a piece of X, I need $100,000. But I don’t have $100,000; I only have $20,000. So, I borrow $80,000. Then I use that to buy X. If X pays well, then what I earn from $100,000 of X will be worth more than the interest on my $80,000 loan. So I come out ahead. And the bank gets an $80,000 loan that they can wrap into an investment package, and sell it to some other sucker.

But if my investment in X doesn’t pay off – in fact, my $100,000 worth of X ends up being worth only $60,000, then I can’t repay my loan. So the bank is out $20,000 plus interest. But it’s not really the bank; it’s the other investment that they sold my unpaid loan into. So now someone else, who invested in a something that was supposedly safe, finds that part of their investment has been lost. And ifthey also borrowed money to make their investment, then they’ll pass on the trouble.

Of course, it gets even stupider.

When you go to buy debt as an investment in the form of a bond, you get a ratingwhich supposedly tells you how much of a risk you’re taking on with the investment. There are ratings like "AAA", which basically mean that there’s no foreseeable way that you’d ever lose your principal on the investment.

Who gives the bonds their ratings? Businesses called bond-rating agencies. And what do they get paid for? Supposedly for accurately assessing the risk associated with the bond. But who pays them? The business issuing the bond. If agency X doesn’t want to rate something "AAA", but agency Y will, then the bond issuer can just take their business from X to Y. Since the ratings agency aren’t actually legally responsible in any meaningful way if their ratings turn out to be a crock of shit, that means that their primary interest as a business is to keep their customer happy – and their customer isn’t the investor; it’s the people selling the investments. So they’ve been giving ridiculous, indefensible ratings to things, claiming that they’re absolutely, 100% perfectly safe even though they’re garbage.

I said that politics comes into it. The way that politics comes in is that this kind of stuff shouldn’t happen. You shouldn’t be able to buy "insurance" that can’t ever pay up. You shouldn’t be able to represent something as safe if it isn’t. Why did all of this stuff happen?

In a word: deregulation.

One of the big trends in American politics is deregulation. Right-winger’s in the government have been constantly harping on the idea that the free market is the perfect solution to any and all problems. Anything that restricts the market – any rules or regulations imposed on it – are inevitably a bad thing, which can never do anything but screw things up. And they’ve worked hard at removing any and all rules that might muddle up their precious market.

Once upon a time, banks had to keep the bank money (i.e., deposits) separate from other things. In fact, they had to keep the entire business of banking separate from the investment business. There were rules about what they could invest in. And so on.

All of this was torn down by the conservatives in our government. And as new financial products came onto the market, instead of making rules to make sure that people were being fair and honest, they insisting on maintaining a strict hand-off policy.

Free markets are great things. But the big catch is that like anything else run by human beings, they’re easy to abuse if you’re not honest. The purpose of regulation is to try to limit the kinds of abuse people can get away with. If someone sells you an investment and tells you that your principal is absolutely safe, then damn it, it should be safe. If it’s not, they should be required to tell you what the risks are.

But for now, they don’t. There’s no legal framework for creating or enforcing rules. No one can be punished for the damage they’ve done. No one loses the huge rewards that they pocketed by screwing people over – because there’s no rules, no legal mechanism, that says that they can’t. As I’m finishing this article, I just came across a news story. Lehman Brothers is one of the big investment firms that was involved in this. They were forced into bankruptcy as a result. As they’re starting to liquidate and sell off their assets, we learn that one of the last things they did before filing for bankruptcy was setting aside two and a half billion dollars forperformance bonuses for the staff of the New York office. The very people who put the firms money into worthless investments, who ran a hundred year old company into the ground, made sure that before they filed for bankruptcy, they squirreled away more of their investors money to pay themselves bonuses. And that’s legal – they can take that money out of the pool of liquidated assets to pay themselves, instead of leaving it to pay back the people who are owed.