Note: Here's my previous post on this topic.
So, how is it that so many bad bets (giving big loans to people very unlikely to be able to pay them back) were made by so many smart people? Obviously no one was making a single loan of this type and expecting to make money on it, just like no one would make a single bet at a roulette table and expect it to be a money maker. But mortgage lenders combined lots of these loans together into bundles called Collateralized Debt Obligations (CDOs) and then sold these CDOs to financial companies like Lehman Brothers and AIG. CDOs complicated the picture and gave a slick-sounding rationale for why the combination of bad bets might wind up being actually a good bet, just like my buddy's betting system for roulette obscures the bad odds and makes him think he's thought of a way to beat the house.
There are rating agencies like Standard and Poor's (of S&P 500 fame) or Moody's whose main function is to rate investments like CDOs. Lehman, AIG and other banks relied on S&P and Moody's to tell them how likely it was that they would get their money back on these CDO investments. But the rating agencies were fooled by the complexity of the CDOs (i.e., collections of bad bets) and told Wall Street that these were good investments.
So you've got a three-part system: mortgage brokers give big loans to people who can't pay them off, but the brokers don't care because they turn around and sell bundles of mortgages to Wall Street, who were told by rating agencies that the bundles were safe, sound investments. The mortgage brokers and Wall Street did nothing wrong, save from believing the rating agencies' wrong guesses at the value of CDOs.
Banks still don't know how much these investments are worth because, as housing prices continue to fall, more and more people wind up defaulting on these loans. Eventually, banks like Lehman investments lost so much value that the banks no longer had enough money to cover their obligations, like withdrawals and such. And because pretty much every bank is in the same boat, banks can't find anyone (save for the federal government) to loan them money, so they wind up having to declare bankruptcy.
So that, in a nutshell, is one man's attempt to explain the current economic struggles. Any questions?