We have witnessed what some have called “the disintegration of the financial system.” How did we get here? How did some bad subprime mortgages lead to what is beginning to look like the collapse of capitalism?

Underneath all the financial jargon is a fundamental truth about banking: that it is based on a kind of confidence trick. It’s called “fractional reserve banking.” Alone among commercial institutions, banks are allowed to create value out of nothing—in other words, they are allowed to lend money they don’t have.

At any one time a bank may have, say, $1 billion in assets, but it will have loaned out at least $10 billion. That $10 billion will yield interest, earning money for the bank—but it’s interest on money the bank doesn’t actually own. Magic. Money for nothing.

But this magic only works if the debtors the bank has loaned to don’t default on their loans, and if the savers who have placed deposits in the bank do not try to take them out all at once. If they did, then the bank would rapidly become insolvent, because of the $9 billion (or more) it has loaned out that it never had in the first place. That’s what started to happen recently: The confidence trick began to fail.

Central banks try to control the value of their currency by manipulating interest rates, the rate they charge institutions, businesses, and people who borrow money from them. For the past 20 years, the banks have constantly cut interest rates. Low interest rates make it less expensive to borrow, so more money is borrowed and circulates in the economy, stimulating it.

People could borrow money easily, so they did—and often investing in real estate, bidding its value way up, far beyond what it was actually worth.

Instead of lending ten times the value of their underlying assets, investment banks started lending out 30 times their asset value. After all, by leveraging their money and using all that they had or could borrow, they gambled that they could make much more money.

If a big bank has loaned out 30 times its assets, for example, it may have loaned out $3 trillion on the basis of only $100 billion in reserves. If those assets lose half their value and the bank suddenly has to come up with the cash it owes, it then finds itself in the hole to the tune of $1.5 trillion or more.

Greatly simplified, this is what happened in 2008. The huge Wall Street investment banks, and the thousands they did business with, whose assets were largely based on house values that were plummeting, awoke one morning and discovered that they were, in actuality, broke.

Grant Montgomery: Grant's Rants on the Credit System