The root of the problem (in the US) comes down to leftist politicians who required banks to lend more money more often to higher-risk borrowers* (originates in the 1970s under Carter, expanded under Clinton in the 1990s).
More (unqualified) borrowers looking to buy houses fueled a housing construction boom.
The boom created a large demand for labor and materials, causing the cost (and valuation) of homes to rise higher than inflation (the bubble). About this time, conservative politicians started to see the end result on the horizon, and pushed to scale back the high-risk lending requirements and more closely regulate the high-risk instruments. The liberals (pocketing money from the pseudo-government companies pushing and insuring the high-risk instruments) said everything was fine, leave it alone (around 2005).
The housing boom eventually led to an oversupply of houses, though this was not so obvious quite yet, as people kept buying.
Expanded crude oil demand from China, India, and other developing nations (plus a growing number of less-efficient vehicles in the US) resulted in higher oil prices.
Rising fuel prices caused the price of everything to increase (due to shipping, raw materials costs, etc).
Rising interest rates caused borrowers with initially low variable-interest-rate loans to pay more each month to service their excessive debt.
The combination of inflated prices of fuel, goods, services, and debt repayment caused the overextended borrowers to default because they could not pay their monthly bills.
As the homes went into foreclosure, it became clear that there were more homes than people to buy them, thus there was no relief for the banks left holding the property - no way to liquidate the assets, since there was no one willing (or able) to buy them.
The banks then lost share price (and thus more liquidity) as it became obvious that the defaults were destroying shareholder dividend profits.
The losses exceeded the ability of some banks to absorb, causing those banks to fail.
However, the free market can take care of itself - Citibank is purchasing Wachovia, Chase is purchasing WaMu, and other deals will likely be in the works. They are doing this without $780 billion from the government.
The bottom line is interest rates will go up for a while, the economy will slow down for a while, the dust will settle, and life will go on. The free market works fine if the government will refrain from meddling with it in stupid attempts to create "legacy" for a few selfish, greedy politicians.
*** Higher-risk borrowers are of any income level where their debt-to-income ratio and/or creditworthiness are insufficient for a prudent lender to expect the borrower to be able to repay the loan without defaulting. Anyone of any income level could become overextended, not just the poor.**