If you still aren't sure why a bailout is necessary, how our current financial crisis came to be and why it isn't just the fault of greedy Wall Street investment houses, you owe it to yourself to read this entire post.

By the end, you'll see how declining spending power, a booming housing market, lax regulatory oversight and profit-driven banking all interacted to get us into this mess. You may even see why the $700 billion program is critical to our economy and why we are in for a long, deep recession even if the bailout plan works. Yes, it's long, but trust me. I even sprinkle a few jaw-dropping charts into the mix.

If You Have to Ask, You Can't Afford It
When Barack Obama says American workers have seen their annual wages decline by $2,000 since George W. Bush took office, he's talking about "real wages," what your pay is worth after accounting for inflation. A stunning example of the decline in real wages is last month's report by the Bureau of Labor Statistics. It shows that average real wages dropped .8 percent from June to July, after adjusting for inflation, which rose a staggering .9 percent in July.

In other words, if you're anything like the average worker, what you can afford to buy just dropped nearly 1 percent. In one month alone. Because of recession and accelerating inflation, about half the cut in your real wages since 2001 has come this year.

If It's On Sale, Why Not Buy It Anyway?
The decline in buying power hasn't kept people from trying to buy houses. In fact, until the housing market leveled off and began sliding about three years ago, Americans were buying and selling houses at a record pace over the past decade. More new homes were sold in 2005 than any year in history. Same for sales of existing homes.

How could so many people afford to buy houses while their real wages were dropping?

The answer isn't just that Americans are conspicuous consumers. We are, but that's not a new phenomenon. For a hundred years or more, we've spent more per capita than the rest of the world's people on almost everything. (Trivia: New Zealanders buy more ice cream even than Americans.) No, conspicuous consumption, while contributing to the "Housing Bubble," doesn't by itself explain why home sales rose so fast over the past decade.

One reason is that many Americans who took out loans to buy homes—sometimes even at prices they couldn't afford on current wages—expected their wages to rise. We have always been an optimistic people. And when George Bush told the country to shop after 9/11, well, some folks may have taken patriotism to an extreme while betting the boss would give them a raise.

But there are three other, more important reasons they bought homes they couldn't afford. Those reasons are relaxed regulations, skyrocketing home values and easy credit.

.40 Acres and a Mortgage
Beginning largely in the 1970s and continuing into the early years of this century, the federal government authorized a spate of laws and regulations barring housing discrimination against minorities, the aged and other historically disadvantaged groups. Democrats believed the laws and programs would level the playing field for their constituents. Republicans believed more home ownership would enlarge the base of conservative voters.

Home Lenders Feather the Nest
If more home ownership was the goal, why not make more people eligible for loans? Enter the Gramm-Leach-Billey Act of 1999, which repealed Depression-era regulations on banking, paving the way for widespread use of subprime mortgages. The legislation's author was Phil Gramm, who became a highly paid lobbyist for Swiss bank UBS and, later, chief economic adviser to John McCain.

USA Today explained the ensuing growth of subprime lending in a 2004 article:

Deregulation allowed cross-fertilization between banks and financial service firms, while the federal government in the 1980s lifted mortgage interest ceilings. Congress in 1986 ended the deductibility of consumer debt, such as credit card payments, though still letting filers deduct mortgage interest. The change provided incentives for refinancing. Even rates for subprime loans at 3 percentage points above prime loans, or about 8% to 9% now, are lower than many 18% credit card rates.

Advances in risk modeling have produced standardization. The bond market for subprime loans has provided cash.

The majority of subprime mortgages are now sold by the initial lenders, bundled into bonds and offered to individual and institutional investors. In 1994, $11 billion of subprime mortgages were sold on the secondary market; in 2003, it was more than $200 billion.

Since 1999, one type of subprime loan in particular, the Adjustable Rate Mortgage (ARM), gained popularity with mortgage lenders as the most potentially lucrative and least regulated loan type ever used outside of loan sharking. Eventually, it became the most devastating time bomb ever inserted into the American economy. As an MBA National Delinquency Survey noted:

In the third quarter of 2007, subprime ARMs only represented 6.8% of the mortgages outstanding in the US, yet they represented 43.0% of the foreclosures started. Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.

Good for You, Good for Us, What's Not to Like?
Owning a home has always made long-term sense for personal finances, but it began making even more sense in the late 1990s as all the factors we've discussed began to dovetail together. Poorer Americans wanted a piece of the American Dream and they were bombarded with offers for home loans at low interest and no interest, or with low payments and no credit— even no job—required. In the days of abundant credit only a decade ago, Americans began buying more homes. And thus was born the Housing Bubble. If you want to see a stunning graph of this, click here.

In just eight years, home values doubled. Suddenly, a house wasn't just a good investment, it was the kind of investment you could later sell to finance your retirement. As prices rose, home ownership became even more attractive, leading to more buying, more lending and more homes being built. Speculators got in the show. The market supplied houses as fast as anyone could get a loan. And then as suddenly as it began, the bubble started losing air.

The Birth of the Blues
Across the country, Adjustable Rate Mortgages began to reset at higher rates. Literally overnight, $700 monthly payments became $1,200 monthly payments and $1,200 payments became $1,700 payments. All of it was legal, all of it was in the fine print, and none of it made sense for either lenders or borrowers. Defaults started coming thick and fast in late 2005. Foreclosed homes glutted the market, raising the inventory of homes on the market to the highest level in 25 years. Home values began dropping in 2006, accelerating by last month to their lowest values in 17 years. Some people even walked away from their homes, choosing to kill their credit scores instead of making high payments on homes not worth the money they owed.

Banks were in a similar position, only worse. They held the homes, true, but those homes were now worth far less than what the banks had already paid to the original sellers when they issued loans to buyers. They held worthless IOUs for the hundreds of billions owed on millions of homes they could not sell on the real estate market.

Poison Pills (Gulp)
Some banks had sold some mortgage loans before the problems became a full-fledged crisis. Large commercial banks and Wall Street investment banks routinely purchased mortgages of every kind, bundling them together and issuing bonds against their value. Credit default swaps, which allowed unfettered trading of these mortgage-backed securities without any government oversight, became more commonplace. Like the Housing Bubble that fueled it, the mortgage bundling business was good for a while. But bundled with the many good loans purchased by the barrel were ARMs and other home loans, whose skyrocketing default rates began to bring financial institutions to their knees. This summer, the largest wave of ARMs reset to higher interest rates, forcing up default rates even higher and making more loans virtually worthless.

The list of institutions that have failed or been sold recently bears striking resemblance to USA Today's 2004 list of which were investing in subprime loans. Countrywide, Lehman Bros., Morgan Stanley and others are all in that Who's Who of the Extinction to Come.

Epilogue
There are at least 3 million subprime loans out. The default rate topped 25 percent by March of this year. At an average home value of $200,000 at the peak of lending in 2006, the subprime loans in default now leave banks with at least $150 billion in worthless securities. Yet even that red ink is dwarfed by the devaluation of the roughly 10 million "good" mortgages that is killing lenders.  It easily totals over $1 trillion.

Note: Several charts and graphs I linked to in JPG format came from http://calculatedrisk.blogspot.com and its associated articles.