The Cause
The match that lighted the current crisis can be found in the sub prime mortgage market. A wonderful euphemism for mortgages sold to people who can not (or just barely) afford them. These mortgages where sold, based on the assumption that the raise in the value of the realty could finance the payments on the loan and not so much the income of the buyer.
Several circumstances led to a strong increase in the sub prime market. Or put differently, decreased the credit standards set by banks.
First: The economy had been stable and/or growing for a long time.
Second: The prices of realty had been growing consistently for a long time.
Third: Margins on loans had been decreasing.
Fourth: There was a lot of liquidity in the market (many investors where willing to commit money).
Fifth: New financial innovation (debt securitisation) obscured the view of the risks.
The stable economy and rising real estate prices led to a general underestimation of the risks in mortgages by banks. The small margins caused banks to actively seek the edges of acceptable risks. The underestimation of the risk and misunderstood financial structures caused them to unwittingly cross that line. The ample liquidity made it all possible.
To put it a bit less formal and a bit more crude. Banks got greedy and like love, greed is blind.
The above mentioned circumstances led to a general decrease in the credit quality (especially for the sub prime mortgages), without the banks and/or investors noticing it. This powder keg slowly grew until it was ignited by an interest rate raise. The raise had two effects. First: many of the sub prime mortgage loaners were not able to pay the higher rates and defaulted. Second: the real estate prices stopped growing. This caused a sudden realization among banks of the predicament they were in. More and more home owners were defaulting and the banks backup (the collateral e.g. the homes) was melting away.
The question remains why this had such an impact on the financial markets? The total expected los from the sub prime market should be easily absorbed by the banks. The effect is because of insecurity among banks and investors. Many of the mortgages where packaged and sold on the market. This means that the loans were placed in a separate company (structured investment vehicle or SIV) and subsequently investors would finance that company using bonds. By using separate companies these mortgages did not show in the banks balance sheet and no solvency needed to be held for them. This seemed reasonable as the perception was that the investors who bought the bonds carried the risks.
However this turned out to be a wrong perception. Because investors saw the sub prime mortgage deteriorate they lost interest in buying the bonds. As mentioned before, banks tend to loan for shorter terms themselves then the loans they sell. In other words the bond to investors had to be repaid before the mortgages from customers were repaid. As bonds from investors became due and no new investors were available to sell the bonds to, banks were confronted with two choices:
1. Do nothing and let the SIV go bankrupt (for not repaying the investors).
2. Pay the investors out of their own pocket and take the mortgages back on their balance sheet.
Many banks chose option 2. Either because they where contractually obliged to, or to save their reputation. This led to insecurity as to which bank or investor actually bared the risk of the mortgages and who would have to take the losses. This insecurity led investors to stop investing money in general. The bank with which you would do business with, could be in bigger problems than it could handle. There was just no way of knowing. Thus the crisis which started with the sub prime market spread out towards the entire financial market and the liquidity crisis was born.
This insecurity is also visible in the media. It is the reason for the many speculations of the total loss that will have to be taken due to the sub prime crisis. It is also the reason why any additional provisions or write offs by a bank is headline news.