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This is Part 1 of Jim Cramer's series of posts on Ben Bernanke's plan for the Federal Reserve during the current credit crunch. Read Part 2, Part 3, Part 4 and Part 5.

It's time to look at what will happen now that the Fed has staked out a position that bails out neither the hedge funds, nor the mortgage companies, nor the 7 million homeowners I believe borrowed money between 2005 and 2006 that they can't repay to take down houses that are worth less than they paid for them.

In other words, what's Ben Bernanke's plan? And why could it actually work and leave us, a year from now, a much stronger, better country? Or to put it succinctly, what happens if Bernanke's right, and what could go awry if he is wrong?

Just for the record, I'm betting that the cost of Bernanke's plan and the possible effects of it on the real economy and on real people are too great, and I have staked out the position that he's going to hurt the country with it. But I have to admit that after the hurt we could end up being in a decent place.

In this multiple-part series, though, I am going to take Bernanke's side and show you how his smart but conceivably heartless plan makes sense -- might even be brilliant -- if it works according to plan.

First, let's set the stage of what Bernanke's aiming at destroying

even if

the

Federal Reserve

, under Alan Greenspan, actively aided the speculative process.

Ever since Alan Greenspan lowered rates dramatically to get the economy moving again after 9/11, it made sense to buy a home with limited financing. Home prices had moved up steadily pretty much since the 1930s in this country and they have been a terrific way for Americans to build equity.

Both the Bush administration and the Federal Reserve actively promoted home ownership, but, for the sake of this series, let's take their actions off the table. They simply did what had always worked: making homes more affordable.

Unfortunately, they made home

too

affordable, so affordable that it made sense to buy more than one, or, in many cases, nine or 10. The homebuilders cooperated by buying as much land as they could and building homes for a couple of hundred thousand dollars and selling them for more and more each year, a truly great scenario for their gross margins. It's why homes became growth stocks instead of cyclical stocks.

The homeowners did great, with the ones that put down the least doing the best. In a typical 2 and 28 loan, a teaser loan, homeowners could put down next to nothing for two years and then, if they wanted to, flip the house or refinance at the low short-term rates the Fed set.

Banks had always loaned to homebuyers and either kept the loans on their books, particularly the high loan-to-value ratio covenants made to people with good credit and a lot of money down. The ones that weren't as good credit were put together into big baskets and sold as mortgage-backed bonds to institutions that wanted to get a better rate than Treasuries for what looked like it wouldn't be a lot of risk at all.

The business was so good and there were so many loans to make that mortgage brokers sprung up all over the place. Unlike banks, these institutions had no deposits to loan against. Instead, they used loans from major banks to originate the mortgages and put them in baskets, too.

The boom was so great that, after awhile, the mortgage brokers and the banks grew sloppy, many times giving loans to people who should not have gotten them and asking them to put almost nothing down. Remember, the economy had gotten strong, employment was strong and houses still appreciated.

Things hummed along. The mortgage bankers accessed low-cost money as the investment banks moved in aggressively to package their loans and make a ton of money selling them to everyone from insurance companies, such as

AIG

(AIG) - Get American International Group, Inc. Report

, to banks, like the German and French banks we learned about this week, to hedge funds.

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The latter had a particular appetite for these bonds, because they could take capital, borrow 10 times against it, buy these mortgage-backs and make the difference between the mortgage bonds and Treasuries. It was a simple, consistent trade that investors loved, particularly funds of funds, which supply the capital to most of the big hedge funds these days.

In fact, things got so out of hand that beginning in late 2004 mortgage brokers lent homeowners not only mortgages but home-equity loans on top of the mortgages. It made sense, with homes appreciating between 10% and 20%

per year!

Even homebuilders got into the act in the end, seeing a quick way to sell homes and make extra money.

While new home sales grew to more than 1.5 million a year, another roughly 5.5 million buyers purchased homes from 2005 to the end of 2006. Of these, probably 50% elected to take teaser rates, and many then took home equity loans on top of that. We don't know how many did that double-shot, but from the looks of things, it could be as high as 20%.

Some of these loans were covered by mortgage insurance. Some were small enough to be sent to

Fannie Mae

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for packaging, but Fannie Mae had gotten in a lot of trouble for a few years back based on mismanagement so it wasn't able to buy as many as it used to. Its regulator, OFHEO, had cracked down and limited its ability to borrow -- the caps you hear about. Same with

Freddie

undefined

. They pretty much became irrelevant to the scene.

Throughout this period the Fed sensed, correctly, that the economy was overheating -- and took interest rates up 17 times to slow things down.

But the rate increases didn't slow things down and the economy boomed, employment remained high and houses continued to sell well.

Until the fall of 2006.

This is Part 1 of Jim Cramer's series of posts on Ben Bernanke's plan for the Federal Reserve during the current credit crunch. Read Part 2, Part 3, Part 4 and Part 5.

At the time of publication, Cramer was long AIG and Fannie Mae.

Jim Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for

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