http://www.wanderings.net/notebook/Main/HowSewingMachineWorksGreatIllustration made it more clear to me... the yellow thread is actually going around the entire mechanism that feeds the green thread. If the green thread were really long, the yellow loop would have to thread itself with the green thread by passing over the the far end and returning. In this case it's a little spool suspended with, if ulab is correct, magnets, so that the yellow thread can pass around it.

If that's still not clear, imagine instead of the green thread going through that whole contraption, you were holding a spool of green thread. When the yellow thread makes a loop and drops down you would pass the green thread through the loop and unwind some of the green string. Then when the yellow thread went up the material you are sewing would shift back until you're back on the other side of the yellow loop ready for it to drop and pass the spool of green thread through.