As others have pointed out, the primary cause of the meltdown is the excessive leverage in the system, coupled with the normal fluctuations of the capital markets.
To give an extended example, a homeowner could borrow up to 95% (~20:1 leverage) of the value of the home, using a stack of two mortgages. These mortgages were then packed up into a CDO (a stack of bonds with hundreds of mortgages as collateral), with the debt portion of the structure standing on top of a 3% "equity" slice (~33:1 leverage). To get the highest value out of the bonds, the originator "wrapped" some of the bonds with an insurance policy or credit default swap, provided by counterparties who collateralized their end of the swap with as little as 3% of the notional value of the swap (33:1 leverage again). The largest investment banks who held a lot of these securities were leveraged at anything up to about 33:1.
Now, imagine that one of two things happen: 1) interest rates on floating rate mortgages increase by 200bp (say from 4 to 6%) within a year, because times are good and demand increases or 2) the value of the homes decreases by >5%, because times are bad and demand is slack. Your equity in a 95% leveraged house is now negative. As a result, some percentage of you have just defaulted; if that percentage is >3%, the CDO is underwater. The string of credit is jerked back, magnified at each step, until you arrive at the current credit freeze.
As a practical matter, what's a reasonably safe amount of leverage? My guess is it's somewhere in the range of 5:1 or 10:1. Using fancy mathematical models, you will get answers like the 33:1 structures of the paragraph above; these models need to go in the garbage at this point. This economy is going to continue to delever over the next 19 months, and it's going to hurt.
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