What Happened To The Economy?
I asked in the comments on a post for somebody in the know to lay out an overview, and Bret sent me here, to A Brief History, and "A new concept: reward good behavior." An excerpt, but read the whole thing at the link for the details:

The current housing collapse and associated financial meltdown were the consequences of a bubble. There has been considerable analysis of how this happened. We had low interest rates, a government program to increase home ownership and a delusion that housing prices could only go up. In addition to those mechanisms, we had a drive for high yields and resulting extreme leverage in the financial services industry. Something similar to this occurred in Orange County, California in 1994 when the county Treasurer got caught in a classic short squeeze while investing in bonds and their options. He was betting on an arbitrage between short and longer terms rates. When rates rose, his investments fell in value. Unfortunately for the County, the investments were highly leveraged and the fall in value triggered what in effect was a margin call.

...More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens. "The price was absurd, and they were giving her a low-down-payment option-ARM," says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he'd hired back in 1997 to take care of his newborn twin daughters phoned him. "She was this lovely woman from Jamaica," he says. "One day she calls me and says she and her sister own five townhouses in Queens. I said, 'How did that happen?'?" It happened because after they bought the first one and its value rose, the lenders came and suggested they refinance and take out $250,000, which they used to buy another one. Then the price of that one rose too, and they repeated the experiment. "By the time they were done," Eisman says, "they owned five of them, the market was falling, and they couldn't make any of the payments."

But that wasn't the end of it.

Moses actually flew down to Miami and wandered around neighborhoods built with subprime loans to see how bad things were. "He'd call me and say, 'Oh my God, this is a calamity here,'?" recalls Eisman. All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.

Thus, the financial paper based on the mortgages far exceeded the amount of the purported assets backing them. Well, that collapse has occurred.

...The country faces three major economic problems: (1) making liquid the troubled housing debt that is clogging up the books; (2) stabilizing home prices; and (3) improving household cash flow. Each can be more easily achieved by rewarding virtue than by continuing down the current path.

The government should offer the option of a new mortgage to everyone now holding one, be it from a Government Sponsored Enterprise like Fannie Mae and Freddie Mac, a bank, or a mortgage broker. The principal amount would be the same as the existing mortgage. If the home-owner had two mortgages or a home equity line, they could all be rolled together into one new 30-year fixed rate mortgage. The new mortgages should have a substantially lower interest rate than existing mortgages. I suggest 4 percent, but the rate could be slightly higher without affecting the program.

This is a bit like the proposal McCain made during the campaign with one big exception. It would be offered to homeowners who are NOT in danger of foreclosure. It would be offered to everyone but with one significant provision. It would be a "recourse loan." You would have to repay it even if your house sold for less than the amount of the loan. Recourse loans were common when I bought my first home. It never occurred to me that I could walk away from the home. The other provision would be that the loan would be assumable, another feature of mortgages 40 years ago.

...What is the benefit of such a program ?

Given the risk-averse nature of current markets and the lack of any real information, it is likely that the market price of the mortgage pool is well below the actual likely outcome. But no one knows for sure. As a consequence, Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) are clogging up the financial system.

Under the refinancing option, this problem goes away. The world is divided into two sets of homeowners: those who think they will repay and those who don't. Those who think they will repay take the new government mortgage. The old mortgage is repaid. All of the MBS and CDOs in the system therefore face immediate full-dollar repayment of all the "good" loans in the mortgage pool. Everything that is left can pretty much be written down to pennies on the dollar. The uncertainty regarding securities pricing is gone. Banks and the financial markets know with a good deal of precision what each security is worth. In fact, they are handed a series of checks for the bulk of the true value of the security as the wave of refinancing works its way through the system. Thus, not only is the uncertainty removed, but the entire financial system is liquefied.

Thus the mortgage market is divided into two groups; those who will stay in their homes and who will repay their mortgages, and those who will not. The first group has a low default rate, the second is probably worthless. It doesn't solve the problem of all the Credit Default Swaps floating out there but they are lost anyway. The market can resume to function. It sounds to me like a good idea.