Genesis of the Subprime Crisis

What initiated as the US Subprime crisis (over USD 5 trillion in losses) in the last quarter of 2006, soon send the world in dire straits, toppling financial markets worldwide, sending most of the economies into recession, and pushing marginal countries, like Iceland, on the verge of bankruptcy. The crisis was more a result of blind enthusiasm riding on the back of a decade long rally from mid-1990s to 2006, and utter disregard for the fundamental business cycles related to the real estate markets. The market players, during the building up of housing bubble in the US, carried the misplaced optimism that property rates will continue to rise indefinitely, ignoring the fact that the principles of demand & supply affect the realty sector, as much as any other sector and it follows the same expansion-equilibrium-decline-absorption cycle.
Driven by climbing oil and food prices in the world markets in 2006, the inflation rates started climbing. At the same time, with the sliding of property prices on account of oversupply of built-up homes, the cost of the mortgage loans (most of which were adjustable rate loans) shot up for most borrowers. As a result, the loan to rental value ratio began increasing considerably. The matters got worse, as a sizable number of homeowners driving the market rally, were sub-prime borrowers. With the rise in inflation, the purchasing power of the subprime borrowers eroded and they began defaulting on loan repayments. Since, the Alt A, or sub-prime loans (for the borrowers with no, or inferior credit records) carry higher interest rates than prime loans, the lenders freely offered loans when prices were rising. The US Government encouragement to subprime lending, especially through its sponsored organizations, Freddie Mac and Fannie Mae, added steam to the then rallying markets. The highly developed secondary mortgage market in the US, and its inherent financial engineering techniques fueled the crisis further. Investment banks and other financial institutions repackaged the mortgage loans as MBS (Mortgage Backed Securities) or CDO (Collateralized Debt Obligations), thereby maintained money supply for further lending, apart from taking large exposures in such securities.
Year 2007 started on a grim note of an impending possibility of an approaching financial turmoil, and by mid-2008, it became clear this predicament would not remain limited to the US. The fall of 158 year old Lehman Brothers triggered a chain reaction world over - the leading institutions at the Wall Street were wiped out, the world stock markets crashed, the credit lines froze, the business activities dipped and there was an overall liquidity crunch.