It all started with the bursting of the dotcom bubble. To stimulate the US economy, the Fed lowered its discount rate to 1.75% in 2001. That fueled investment and also comsumption. The housing market took off.
Developers were having a good time. They offered free money to purchasers for down payment. The mortgage firms were doing a roaring business. Everybody could and were buying houses - even the less credit worthy ones. Loans to this group were called subprime.
The investment firms gave the subprime mortgages a spin and created a derivative out of them called Collateralised Debt Obligations (CDO). The CDO is a leveraged instrument. This debt is then sold to hedge funds, banks and other investment houses.
The Fed increased its discount rate to 5.25% in 2004. This increased the mortgage payments. The inevitable happened. What goes up must come down. The housing market softened. Subprime borrowers started to default on their loan payments. This triggered a selldown on the CDOs. At its worst, nobody wanted the CDOs. As such, there was no market price for the instrument.
Redemption of the CDOs were stopped. Bear Stearns declared two CDOs worthless. A german bank was bailed out. This caused a world wide credit crunch. Central banks pumped in hundreds of billions to shore up liquidity.
Sentiment turned sour. The unwiding of carry trades caused a currency turmoil. Exchange rates swinged wildly. Share markets also got hit. Billions of wealth was destroyed. Everybody gets poorer. What a sad episode.
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