It's a convoluted story, but I'll try to simplify it. The 6 line version is:

1. People like to trade things, like mortgages, because it spreads risk and wealth. Prior to the 1980's a lot of these mortgages were bought in pools by Fannie Mae and Freddie Mac, which were government commissioned companies (created in the 1930's, and 1970's, respectively) that helped drive the housing markets. In the 1980's, this became much more deregulated, and all of investment banks got in on the game.

2. For a variety of reasons (debt burden, burst of the housing boom), houses are worth a lot less and lots of Americans have defaulted on their mortgages and other debts lately. Banks are thus "foreclosing" their houses and auctioning them off at much lower prices.

3. Thus, a lot of things that banks THOUGHT they owned actually are worth a lot less than they were. They're also not getting the interest income one would expect from owning these things. There's less wealth out there (we don't exactly know how much, but it's somewhere between half a trillion and a trillion dollars).

4. Banks that whose asset base was largely based on mortgages basically lost a ton of value and the math no longer works -- they can't really lend more money out as they don't have enough "safe" assets to offset the risk. A couple of these have been repossessed by the government for this reason (Fannie Mae, Freddie Mac, and now Washington Mutual). And when customers get nervous, they will withdraw their "real assets", otherwise known as a bank run Thus couple investment banks also had a ton of mortgages, and they didn't have enough "other real stuff" to balance out these losses or to tolerate the runs they were experiencing, and so basically either have to join forces with another bank (e.g. Bear Stearns was fire sold to JP Morgan Chase), or go bankrupt (e.g. Lehman Brothers).

5. When there's less wealth, there's less willingness on the part of banks & traders to loan money or to take risks on new forms of wealth creation (e.g. entrepreneurs). This is referred to as a "credit crunch". There's also less willingness to trade their other assets (e.g. ownership stakes in companies or contracts) because they need them to balance out the risk of the debt that they DO own.

6. A growing economy depends on credit as lubricant. It's essential. If your country lacks credit, the country basically can't create money. Good luck buying a house or a car, or getting a business started. An economy that isn't growing is basically "failing", because it becomes a zero-sum game -- any gains MUST be someone else's loss. Bad things ensue.

That's the situation the United States is in.

The Paulson recovery plan is a theory that they can fix the system by having the government buy all the "risky mortgage debt" that's causing the credit crunch, thereby taking on that risk, and hoping that the market will "discover" the right price for new credit because risk levels will return to "normal". Now, it's not like the government would lose $700 billion, they're just taking the risk on any future foreclosures. The end result might be that the government loses a bit of money or makes a bit of money, we don't know.

The problem with the plan is that they asked for "zero oversight", so the money could be used for corrupt purposes and really provides no hedge for the taxpayers if more foreclosures happen. They want "money for nothing and chicks for free".

The Dodd/Frank alternative plan is more inline with what normally is required to inject capital in the financial system -- the government would take ownership stakes in the banks in exchange for buying their risky assets, and they would limit executive pay to prevent rewarding the dodos that caused this mess. This is useful because it provides EXTRA actual value to cover the risk inherent in the assets. But, Congressional Republicans HATE this idea because it sounds a lot like socialism (government owning the banks and reducing the wages of executives). Of course, the world is a lot more complicated than this black & white interpretation of Capitalism vs. Socialism, but politics doesn't like nuance.

Roubini has a third idea: fix the underlying problem! Everyday Americans have been defaulting on their debts because their debt burden is way too high. Despite an improved economy and improved productivity, the wealth has NOT been represented in increasing wages in American workers. There are many theories as to why this is -- short-term thinking, negligence, greed, globalization, the shrinkage of unions, systemic ignorance, or flaws in our economic/financial regulations. Meanwhile, prices continue to crawl upwards, and consumerist culture remains an American beacon.

In the short run, Roubini's answer is to BOTH do the equity stake in financial institutions to inject capital in these companies burdened with risky assets but ALSO (more importantly) lighten the debt load on Americans. The long term answer is to fix the system so that wages return to their pre-1970's levels of growth.

In summary: Everything in our economy is intertwingled. That's the price of efficiency. But if it becomes socially (and legally) acceptable to take on large levels of risk, one crack can lead to a market-wide failure. Expect this pattern to continue: peace & prosperity followed by moments of intense and widespread chaos.