Articles, books and college courses have been offered up to try and answer that question. Following is a brief, simplistic, but factual explanation of the “why” to the question.

First, imagine the entire financial community as a circle. Now, let’s start with one subprime mortgage with the understanding that this one is one of millions.

Subprime by definition is a loan where the borrower has poor credit and minimal or no equity in the transaction. The combination of subprime lending and the federal government’s incentives for homeownership created a new sizable demand for homeownership. This additional demand fueled an annual appreciation for home prices that reached record levels. Lenders gained more confidence from this appreciation, and were further motivated to increase the size of the subprime mortgage market.

The obstacle to creating more subprime mortgages was the lenders’ balance sheet. They needed to create more liquidity on their balance sheets. To do this, the lenders began to sell the subprime mortgages they originated. They pooled the mortgages into packages called mortgage backed securities (MBS) and sold them to investors, other lenders, and Wall Street firms. The packages were repackaged, mixed together, and put into pools with mortgages of different credit ratings. Some of these were sold to hedge funds, foreign banks, etc.

MBS were successfully marketed to buyers. After all, these were American homes that go (straight) up in value and the owners will do everything and anything to protect their home. Unfortunately: Debt investments that inflate collateral value by creating demand through borrowers that have no equity combined with poor credit is a house of cards that will collapse.

Sooner or later either:

Some lender recognizes the folly of this business model and stops their subprime lending. Lending demand declines, and home prices go down. This further validates a continuing downward spiral of housing demand and value.

Or:

A borrower misses enough monthly payments to go into default. Like the Dutch boy with his finger in the dike, one crack is all that is needed to start the flood.

Once either or both of these inevitable events take place, builders stop building, construction workers are laid off, mortgage brokerage firms close, institutions have large write-offs followed by lower earnings and a reduction of employees. Stock prices go lower. The media focuses on negative hyperbole. Lenders stop lending, and eventually credit is unavailable.The Federal Reserve steps in and uses the tools it has available to motivate the creation of redit. That’s where we are now.

NetGain has stated its position many times. The American economic model is not designed to achieve economic equilibrium. Therefore, the American economy is a cyclical economy. Historically, these cycles are the result of excesses (surpluses or shortages) that create artificial value. The subprime mortgage is a perfect example.