This American Life, a podcast show produced by Chicago Public Radio, dives into the credit crunch and explains the mess in a way you can understand. The hedge funds and banks have created a daisy chain of credit and insurance for credit that depends completely on the chain remaining intact. If the chain breaks anywhere, others in the chain now have risk they may not even know about. And the house of cards collapses. That’s what’s happening now and it’s really, really scary stuff.

The problem is that the hedge funds are both buying and selling this stuff, making money on the spread between what they can buy it for and what they can sell it for. To make the spread bigger, they buy insurance on a company’s debt, then short sell the stock to put the debt in danger, and then sell insurance at a higher price to cover the their position. Making boatloads of money in the process.

Add leverage and we now have a mountain of “fake debt” that inflates the debt market from a real debt market of about $10 trillion to a leveraged debt market of $55 trillion, which basically means that there is something like $45 trillion of this fake debt where the collateral is an insurance policy on some other piece of debt.

This is a money making machine, until the daisy chain breaks somewhere and they have to unwind their positions. That creates huge requirements for cash throughout the system at a time when no one wants to lend cash. That means more players go belly up and amplify the problem.

This is a long podcast, but if you want to understand why the market is crashing, why you can’t get credit and why the government was panicked enough to do the bailout you should listen to this.