OK, I'm going to delve into some technical accounting stuff. I'm not trying to excuse the companies bad decisions, but just want to bring up another aspect of this situation that we haven't covered. This will also really show the true dork that I am.
Anyways, there is an accounting concept called "mark to market". This concept requires companies to change the value of their "liquid" investments to the current market price (regardless if they plan on selling the asset or not). So, given the non existant Mortage Backed Security Market, MBS, (or Collaterized Debt Obligation, CDO) these assets are being written down to fractions of their original value. Because there is no demand for them they basically can't be sold. Because they can't be sold their mark to market value is very small.
Now that only deals with current value. The actual security that they hold may have a default rate of say 25%, but given the current market price the bank has to value that asset of say 30% of its original value, instead of the planned 75% collection rate.
So in other words, over the life of the asset the owner of the asset can honestly expect to collect 75% of the value, but they have to account for that asset of only 30% of it's value. This is due to the mark to market accounting method.
Now that I've explained that, we can get into the effect that this concept has on banks. Hopefully, people are following this. Anyways, this mark to market concept causes HUGE writedowns of asset value for banks. This gets booked (accounted for) as an expense so the bank "appears" to lose money. They really haven't lost exactly what they've put down, but they are forced to put that amount. So, the quarterly results look really bad because of the extra expenses taken due to the write down. Also, banks are supposed to keep certain ratios of capital on their balance sheets. The mark to market concept inflates the amount of losses to the balance sheet so banks have to scamble to find other assets to "shore up" their balance sheet to meet regulatory requirements. They try to sell stock and if that doesn't work then they're in big trouble. If customer's start withdrawing their money (bank run), then the problem exacerbates itself until the bank can no longer function and they go out of business.
So, in essence banks have assets on their books that have been written down significantely due to mark to market accounting. This causes the banks ratios to be out of whack and puts the bank in a really bad position of trying to find assets (raise capital/get investments). The bank's typical operations may be making loads of money, but because of the above they can be forced out of business or forced into a "merger".
There is currently a lot of discussions to modify the mark to market accounting requirements.
OK, I'm going to go have another beer and hope that my reputation here isn't that of a major accounting dork. I'm going to include a pic of my personal best just to make myself feel better.