NYT has some excellent graphics on the ongoing financial crisis, the latest of which nicely captures the problem - collpase of the securitization market - and the proposed solution - Government as lender and insurer of last resort.
Banks have come to depend on selling mortgages and other loans to investors like hedge funds and insurance companies. This allows banks to make more loans and earn bigger profits.
But the market for these securities has collapsed, contributing to a freeze in lending.
To encourage new lending, under the new Financial Stability Plan (this will be part of the Term Asset-Backed Securities Loan Facility or TALF, announced in November 2008), the Treasury and the Federal Reserve would provide up to $1 trillion to private investors who acquire new securities (only AAA rated) backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5-3%. Depending on the type of security they are borrowing against, investors will be able to borrow 84-95% of the face value of the bonds. Investors would not be liable for any losses beyond the 5-16% equity that they retain in the investment.
An example of government financing for a $100, three-year security backed by consumer auto loans that typically earns 4-5% annually.
Because investors borrow most of the money from the government at a low rate, the effective return could be 20% or more. Even if the underlying loans default, the investor could lose only up to $8; the Treasury and Federal Reserve would bear the rest of the losses.