The present global meltdown can be termed as a consequence of the explosion of" financial bomb" that had been building on for some years in the US. After the dotcom bubble ,the US had pursued a regime of low interest rate to spur economic activity after the bursting of the tech bubble in 2001. However,this policy led to a frenzy of activity in America's real estate sector leading to rising house prices as a result of rise in demand due to easy avaibility of loans at low rates even to sub-prime borrowers. The banks were under the belief that prices of houses never fall and such houses can always act as collateral in the case of defaults. Now comes our real villain "mortgage backed securities". These loans were sliced and packaged with other financial instruments and sold to investors mainly "investment bank" as 'A or AA ' rated securities.
From 2005 -2007 onwards, FED increased the interest rates more than 12 times to contain the inflationary expectations that had been building in the economy. Since,those loans were disbursed at floating rates, tied to the benchmark interest rate,the interest burden on the consumers began to rise and by then demand for houses had subsided. Initially,there were only few cases of defaults,thereby banks took possession of those houses. But,it resulted in a scenarion of high suppy of houses against a stagnant demand,there by causing a fall in price level in the housing sector.
These falling prices eroded the asset value of many households and in many cases the prices had fallen way below the amount owed by the customers to the banks. This instigated many people to default which inturn increased the supply of houses in the market,causing a further fall in their prices. In other words, there was a race to liquidate the value of the houses,leading to about 20% fall in their prices. Now,the investment banks,like lehmann brothers and merril lynch who had bought the securities backed by these "mortgages" suffered a substantial erosion of their balance sheet .The cash availability had fallen below their working capital requirements by the middle of 2008.These banks tried their level best to get some low cost capital from FED,US central bank, and central banks of some other countries to remain solvent. But that is another story. Finally,in september 2008,lehmann brothers was forced to declare bankruptcy and merril lynch was sold to Bank of America .
Then followed the wave of deleveraging,i.e reducing the debt exposure , that has engulfed the world since september. Banks have become reluctant to lend to businesses and even among themselves thus clogging the credit fow to vital sectors of economy. This is what has been described as liquidity crunch and attempts by central banks of the world to reduce this crunch by reducing interest rates.
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