Like SB said, the main problem is leverage. In the last five years, everyone - banks, corporations, individuals - borrowed too much.

Think of the following situation: a person buys a house by putting down a 5% deposit and borrows the rest. Imagine that the house value declines by 10% or 20% and for whatever reason, he has to sell his house (maybe he lost his job and can't afford it anymore?). That guy is screwed, right?

That is what is happening today. Banks borrowed money to invest in mortgage-backed securities, among other securities. As the housing market tanked, these securities went down in value and became less liquid (meaning no one wanted to buy these securities, so the banks couldn't raise any money from selling). Not able to sell these assets, banks tried borrowing from other banks, but banks with any excess cash stopped lending to other banks because they were worried about their own liquidity. Being unable to sell these assets or borrow from other banks, the troubled bank has to turn to the government - first, borrowing from the discount window and in the extreme, you'll see the Mac/Mae/Bear Stearns bailouts. This problem affects corporations as well because if banks aren't willing to lend to each other, they sure aren't willing to lend to corporations (unless the interest rate is so high that it's an offer they can't refuse). High borrowing costs for corporations affects employees who'll see smaller raises and a higher probability of unemployment.

For the system to be righted again, these companies need to write-off these assets to their true value (which is hard to do because these assets are complicated and hard to value), pay off their debts and institute rules to prevent problems in the future (e.g. increase the reserve requirements, stop relying so much on the ratings agencies, etc...)

As for the individual investor, I believe the best thing to do right now is to not panic. Do not sell all your assets and put it under your mattress. Over the course of decades, the long-run return of the stock market is approximately 7% to 10%. The market has always shown that it will right itself. Although it may take a little longer this time, it will do so again.