The Budget

The reason we're in this mess is because there was a panic in the markets, no? The government stepped in and saved the banks, now we're in huge debt... .

Its about mortgage defaults in the sub prime market.

Loans to people who are likely to default isn't a problem per se - the higher than usual rate of interest reflects the risk to the party making the loan of default; it's analogous to insurance. The fact that the borrower is less likely than normal to actually be able to repay you is priced into the loan repayment. (obviously I'm ignoring the very convincing argument that this is really quite immoral).

The real issue was in the rolling up of such debt with a bunch of other debts of varying risk into Collateralised Debt Obligations (CDOs) and selling them on. Basically, you take a few different debts of varying risk profiles (some very risky, like these sub-prime mortgages, some very safe, some inbetween) and sell them on.

The problem is that these CDOs break the link between the price of the asset (the interest on a mortgage, for example) and the market value of the debt. These CDOs were super complex, to the point that figuring out the actual value cost more than the CDO itself (I read this in the economist a couple of years back, so maybe I am characterising it slightly wrong).

A compounding factor is that the ratings agencies rated these CDOs too highly: they rated them based on historical default rates of sub-prime borrowers, but these default rates were artificially low because of the easy supply of credit. When US people began defaulting on their mortgage payments, the value of these CDOs (which contained as much as 70% sub-prime exposure) plummeted. But because it was so hard to figure out what they were worth, the major banks had no idea what their exposures were.

This meant that they didn't want to lend to anyone - consumers, businesses, or each other. So the money markets dried up (requiring massive injections of capital from central banks). When losses became apparent, they were huge, because the CDOs were recorded on banks' balance sheets at their (artificially inflated) market value. Since the banks are so large, and so interwoven, governments intervened on a global scale to prop up the financial system itself.

So who was to blame? I don't think that's an easy question to answer.

Banks created these exotic financial instruments to create value from risk whilst pushing loans to sub-prime borrowers
Rating agencies failed to take into account the possibility of a collapse of the housing market
Governments failed to regulate on a number of levels: the financial instruments themselves, the availability of credit (esp to sub-prime borrowers), and the formation of bubbles in the housing and financial markets.
People who took out 120% mortgages paying back only the interest payments each month

IMO, it's a question of incentives.

Banks were incentivised to loan to sub-prime customers, because they could make money from selling their debt as CDOs.
Rating agencies were incentivised to give good ratings, because they are paid by the banks for their services.
Governments were incentivised to have lax regulations, because they were collecting a boatload of tax revenue from the financial and housing markets
Consumers were incentivised to take the credit, because that's pretty much how humans operate: behavioural economics shows that people don't act rationally when it comes to offers of loans.

So the real question is how to alter these incentives, so that it doesn't happen again?
Or maybe the underlying question is whose responsibility is it to alter the incentives so that it doesn't happen again?

NB - just my take on things; I'm not a financier, so I probably got a few bits wrong.