Oh where to start.
There are several things happening all at once and while lots of people had a good idea of what was happening I doubt anyone that mattered really understood what was happening or the scale of it. Or will for a generation. There is no quick fix and regulation will make sod all difference to the next crisis, which will arise in a completely new way.
First thing to remember is no one knew when bad things would happen, until the train hits the buffers it’s a fun ride and highly profitable for everyone concerned, much more so than not getting on the train or getting off too soon, until the train hits the buffers.
So.
1. Yen Carry Trade. This means borrowing yen at 0% interest and using them to borrow $ at 4% yield and making money. You can make much more money buying derivatives rated AAA1. Before that it was buying Russian or Asian assets.
2. The US was attempting to increase home ownership so gave an implicit guarantee to back mortgages. It did not however guarantee personal debt borrowed on the increasing nominal value of housing.
3. When house prices fell and the value of the house is below the level of the mortgage its sensible ( in some ways ) to default and booma da banga defaults on other debt as well.
4. Some of these loans were somewhere on the wrong side of fictional. The borrower had no chance of paying the interest but the rate of increase was such that you could buy off plan, wait until the shell was up and make money selling on. If you actually wanted to live in them you would have to borrow to pay the mortgage from the get go, but because the US Govt is backing the loan, and the nominal value of the house is increasing not a problem is it. Until the rate of rise in house prices flattens.
5. This all peaks in 2006/7 and Bear Stearns goes belly up.
Meanwhile.
Various financial institutions were bundling and insuring this in derivatives which mixed up perfectly good mortgage debt with really bad mortgage debt. As the defaults on the latter started off credit default swap insurance kicks in and the insurance companies take an unexpected bath. Historically mortgage debt has a very very low default rate so it has a very big impact on the insurers.
Around about then AIG goes bankrupt more or less and gets bailed out. The reason for this is AIG insures a lot more than CDOs and without that insurer someone will need to step in and ofc, all other insurance companies are in the same business and frantically trying to find out what the hell is happening.
This is a major theme. The CDO were packaged and repackaged and noone really knew who owned what and who was going to get the black spot.
It was Lehman Bros. Who when they go bankrupt do not, unlike Bear an AIG get bailed out.
Up to now this is fairly localised. It mainly affects US and UK banks.But the effect is global cause no one know who owns what bad debt.
This leads to a freezing of short term loans and if you look at it in the UK and US the government very rapidly stepping in as lender of last resort to take over the banking system and make sure lending crawls back. In 2008 16 US institutions, 12 UK were wound up.
Euro zone with a few exceptions the zombies shuffle on. Partly that’s because of lower exposure to the US subprime issue partly because it’s a different problem. There is significant bad debt through CDO permeating the whole system though.
In the eurozone be basic issue is that everyone pegged their currency to the DM and called it the Euro. Here the bad loans were not to individuals directly but to governments borrowing on german rates initially. When the general squeeze on credit happened, it affected all banks and the regular rollover of sovereign debt happened,people were much more sceptical about loans and killed Greece, who were the most vulnerable and badly wounded the rest. Ireland to some extent got away with things, because their issues happened before the US and there was not the panic of system wide bad debt.
The Credit Crunch that followed subprime is much more important for the Eurozone. What it does is highlights the fundamental problems with the Eurozone. The basic bet there was that with a common currency everyone will behave more and more like Germans economically because of they don’t they will shed activity to Germany and its Ilk. While there is borrowed money, at cheap rates that is fine, when the source of lending dries up because the commercial banks are reacting to subprime it becomes a major issue and slows the system. Whether they want to or not the banks do not have cash on hand to lend and the reaction in the US and UK (amongst others) is to require much larger capital reserves vs loan book and that brings the industrial performance issue to a head.
Because the countries are linked to each other through the Euro they cannot devalue their way out – unless Germany agrees and they won’t, they cannot take fast measures because there is no central bank big enough to do things ( ECB is forbidden) so they end up having to internally devalue to regain competitiveness largely by reducing labour costs, by not hiring people. This is against a background of a severe structural imbalance in performance between eurozone members and no guarantee it will work at all. That issue is not that they won’t grow but that they won’t grow fast enough to close the gap with Germany and their ilk.