The Cliffs Notes Version
The BBC’s Robert Peston has a nice simple explanation of what went wrong:
In a nutshell our banks and other financial institutions lent too much against the security of over-valued assets, largely residential housing and commercial property.
And to obtain the funds they lent to households and business, those same banks were too dependent on credit from wholesale and overseas sources (net wholesale funding of our banks went from zero in 2001 to £625bn by the end of 2007).
So when the penny dropped that the value of houses and property was falling fast, two terrible things happened at the same time: the overseas and institutional providers of all that incremental funding wanted their money back from our banks, because the formal or informal collateral underpinning that funding was shrinking; and the capital foundations of the banks were eroded by actual and prospective losses on loans that had been made into those frighteningly pumped-up housing and real estate markets.
In the same piece is a discussion of a major problem for central banks – they don’t really have the tools to deflate bubbles before they get out of hand. The major tool of central banks is manipulation of the interest rate, but that affects everything, not just a single overheated segment of the market. If the Bank of England or Federal Reserve could have affected real estate loans directly, then the bubble wouldn’t have gotten so bad, but they can’t currently do that.
Note: £625bn is more than $ 1 trillion US, and that is only the overseas and wholesale borrowing.
