Bird's eye view on US financial crisis

To recount briefly, there was a housing bubble in the US and it burst. With asset prices falling, there was a rush to sell assets. But if everyone rushes to sell, the prices fall. This leads to a downward spiral called a 'debt deflation'. The housing bubble was created over years of easy money thanks to Greenspan, and subprime mortgage lending. The pendulum of market sentiment swung from the one extreme of greed to the other extreme of fear, as it always eventually does.

To support the banks who went bust because of this mortgage lending, 

1. the US Federal Reserve and the Treasury Department have asked for $700 billion to buy distressed mortgage-related assets. 
   
2. Add to that the $200 billion to rescue the mortgage guarantee firms Freddie Mac and Fannie May. 
   
3. Top it off with the loan of $85 billion to keep the giant insurance company American International Group (AIG) afloat. 
   

The total assistance allocated to prop up the financial system so far – and it is anyone's guess how much more will be spent eventually – is approximately the annual GDP of India, a country of a billion people.

All this spending by the US government will raise the public debt of the US to around $11.3 trillion. That makes it the biggest borrower in the world. The creditors, among others, are the central banks of many countries such as Japan, China, the oil-rich nations, and even India. Many countries maintain foreign reserves in US dollar denominated financial instruments. The US borrows approximately $2 billion dollars from the rest of the world every day. 

Relevant question to ask and find the answer to is: Why does the world permit the US to get away with it?

The answer could be:

It is said that if owe the bank a little money, and are unable to repay, you are in trouble; but if you owe the bank a billion dollars that you are unable to repay, the bank is in trouble. In the larger context, the US owes the rest of the world a lot of money. If it cannot pay it back, the rest of the world is in trouble. Therefore, the rest of the world has to make sure that the US never fails. That is why the US continues to get a massive line of countries(!) credit –- often from relatively very poor countries such as China which has lent the US an estimated $2 trillion.

Why should the US rescue the banks in the first place?

The US government rescued the US financial institutions it did because as noted before they are too big to fail. The US government is able to spend all that money it does not have simply because the US is too big to fail. The domestic financial crisis could have snowballed into an international financial crisis, the beginning of which would have been a crisis of confidence among the investors of the corporation known as the US. All these financial institutions in turn are linked to other financial institutions globally and the contagion could spread unless action is taken urgently. Financial insolvency is contagious. By nationalizing Freddie and Fannie, and giving a bridging loan to AIG, the US government put a backstop to the slide

What could happen next?

Economists estimate that the financial crisis will cost it around two percentage points in GDP growth for the next couple of years because recession in the US is a given. Global economic slowdown is also guaranteed. The financial system cannot be isolated from the economic system.

Which is of course very depressing news for India because India any slowdown of the global economy will adversely impact India's growth.

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The relevant material for this study is from this article in Mail Today.