The fundamental problem is that house prices rose faster than income or productivity for over a decade and this was unsustainable so they were inevitably going to fall. In the case of sub-prime mortgages this meant that the banks had little chance of being paid back on the loans and the collateral of the house itself was suddenly not worth a great deal.
Commercial banks which had a large mortgage of sub prime loans suddenly found it very difficult to raise the money to pay back their depositors' money. The investment banks who bought the debt in the form of some complex financial product then found that much of what they owned was in fact highly illiquid and worth far less than they had believed.
So what should be done:
- Let banks with risky business practices go bust, they remaining banks can buy up their assets at a more realistic price.
- Increase the money supply.
- Include house prices in the inflation calculations, so that when there is a price bubble the banks can raise interest rates to curtail it.
- Don't pass idiotic laws requiring banks to make sub prime loans.