1) The US government, by various means and measures, encouraged a higher and higher percentage of home ownership (the highest in US history).
2) Eventually, all of the "good" mortgage borrowers were used up, in a macroeconomic sense. They didn't need or couldn't be persuaded to refinance or to borrow more.
3) A huge pool of money became available internationally for investing, right after Enron and several other high profile corporate failures. This pool of money sought safe, consistent returns on investments, and mortgages were considered quite safe and conservative.
4) Government policy and this investment money collided, creating a huge market to lend to less and less qualified borrowers. Mortgage banks, investment banks, retirement funds, and various other investors offered and bought up more and more risky loans, on the principle that a certain, well understood percentage of them could fail, but no less than that.
5) To serve calls for more from these investors, big financial institutions created financial instruments that "sliced and diced" large pools of mortgages, and sold them like shares of stock or mutual funds. Banks, retirement funds, and other investors held these shares as part of their assets.
6) Within the last year or so, far more of those mortgages failed and went into foreclosure than the principle, above, allowed. The investors stopped buying them. Investors who held them (and still hold them), now have billions of dollars worth of mortgages (and parts of mortgages) that can't be valued with any certainty. They're probably assets and worth something, but when no one will buy them, it's hard to tell.
7) When your assets have an uncertain value, you can't borrow against them, and you can't make loans backed by them. Banks and other financial institutions stop lending to each other. The inter-bank lending rate goes through the roof for what little funds are still available. This is what has been happening for the last 2 weeks, and part of what has Paulson and Bernanke so scared.
8) The easy flow of money between banks and institutions that we take for granted stops. You can't buy anything at the store this week (even on a debit card), because your employer has to pay payroll out of cash on hand; it can't use a short term loan as usual. But that doesn't matter, because the stores can't afford the cash to maintain a full inventory. But that doesn't matter, because the trucks can't afford the cash to buy diesel to ship goods. But that doesn't matter, because the factories can't afford the cash for raw materials. And on and on. It ripples into the service economy, the entertainment industry, utilities, and (eventually) taxes and government services.
That's what really has Paulson and Bernanke so scared. And they're right to be, but I disagree with a $700,000,000,000 bailout that buys up all those mortgage papers --especially since insiders at the Treasury admit that they pulled that number out of the air, because it just sounded good.
Other good explanations:
NY Times: Diamond and Kashyap on the Recent Financial Upheavals
This American Life #355: The Giant Pool of Money
Kiplinger: 10 Things That Will Change
WashingtonPost.com: Bailout Could Deepen Crisis, CBO Chief Says