By early-2007, it became clear as housing prices began to decline, losses on sub-primate mortgages that originated in 2003-2006 were rising more rapidly than the assumptions used and risk-model predictions. The deterioration in borrowing quality and other shortcomings mentioned above gave little comfort to investors. The losses were hard to estimate, especially in an environment of house-price busts, and given that the sub-prime mortgage-backed security (MBS) had been re-packaged into complex collateralized debt obligation (CDOs) and CDO-conduits were financed by commercial paper and various notes.

The bursting of the housing bubbles in the United States, as reflected in a surge in defaults and foreclosures since mid-2006 in the US, resulted in a plunge in the prices of MBSs — assets whose value ultimately comes from mortgage payments. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt (US financial firms lost over $1 trillion by Dec. 2008). This problem is especially severe because households, corporations, and government took on so much debt during the bubble years (that debt cumulated to over 400% of US GDP and about 450% of UK GDP).

Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs. (US and European banks have been raising capital of about $400 billion from oil-producing countries and China but there is still a large gap as banks continue to write-down bad loans).