The short simple explanation is that banks lent money to people for some amount plus interest then turned around and borrowed money from other institutions for the same base plus a smaller amount and so on. In this way the banks were 'over-leveraged'.
From a commenter on the original post, an example of what leveraging looks like:
The scenario goes like this:
I lend you my last $100 in exchange for a $10 payment at the end of the year and an IOU.
Based on that IOU for $110 payable at the end of the year. To cover my expenses until you pay me back, I borrow another lender's last $90 promise to pay back $95 at the end of the year.
That lender then to cover their expenses, borrows $80 and promises to pay back $82 at the end of the year.
So, based on initial loan of $100, $287 is floating around. A ratio of 2.87 to 1
Now let's say you lose your job, declare bankruptcy and won't be able to repay. I've lost my expected $110. And because I can't repay, the guy I borrowed from lost his expected $95. And because he can't repay, the gal he borrowed from lost her expected $82.
There are estimates that that some banks were leveraged at a ratio of $30 (money they borrowed for every $1 dollar in assets (money they lent)
You can see how these numbers start to add up in a very big way very quickly. Remember, this is all on paper as well under something called 'mark to market'. I believe 'mark to market' means that a bank declares the worth of an asset based on what they believe the market will pay for it, not what will actually be paid.
So games are played with accounting rules about mark to market, so they can continue claiming the assets are worth more, like your neighbor who bought a house in 2006 for $800,000 which, through comps, is now worth $500,000. Said neighbor still telling self and others that the house is still worth $800,000.
This is all fine and dandy as long as those original loans can be paid back and the originator bank can pay back their loans and on down the leveraged chain. The problem starts when large amounts of loans start to default, then the banks can't pay back their lenders, etc and everything goes down the drain.
So did the mortgage crisis cause this? No, it just exposed it. It seems to me that the actual cause was the over-leveraged nature of the loans and the lack of regulation preventing real valuation of assets, rather than the 'mark to market' fantasy.
Now, here is the real scary part and where the insolvency comes in. For a long time people were calling this a liquidity problem, implying that money was locked up between banks and we just needed to inject more in to get it flowing again. That assumed that the bank assets were actually still in the positive. What is becoming apparent is that these banks are totally insolvent. In other words, if they had to actually sell their assets right now at what someone might actually pay for them, they would be in the red very quickly. So these banks don't want to sell because they would go out of business. Instead, they hold on to it and hope things will turn around and make their assets worth what they claim they are worth.
To put another way, if you were a bank and your mortgage were all your assets, what would you do if you owed more than you could sell your house for like 1 in 4 American's are right now (myself included)? You'd sit on it and hope that things turn around if you could, right? That is what I'm doing and by the looks of things, it going to be a much longer wait than I hoped. :(
The sooner these banks are forced to declare how much the assets are actually worth the sooner we can deal with the damage. Until that happens it is just going to be games with accounting rules and money thrown at a problem (liquidity) that doesn't actually exist.
Here is the article that I was referring to...the comments are very informative.