Partially because of the new financial instruments such as collateraised debt obligations (CDOs), which allowed banks and investment banks to "securitize" mortgages and sell them to investors (such as pension plans, other financial institutions). The rating agencies such Moody's gave these new instruments Triple A ratings which made them seem much less risky then what they were.
For example, a CDO is purchased by a bank from another bank that is made up of 30% sub-prime mortgages, and 70% other debt instruments (e.g. corporate bonds). It pays 6% interest. The sub-prime mortgages stop being paid when the homeowners can no longer pay due to the initial favourable variable rate ending and going up to a higher rate (varies when this happens). So the supposedly "low" risk CDO is now high risk. The bank that holds the CDO is no longer getting 6% and the value of the CDO decreases significantly. The bank has to write off this investment on its' balance sheet.
Because of the number of sub-prime mortgages that have gone bad a lot of these financial derivatives have also gone bad causing massive writedowns by banks. Because banks don't know what other banks exposure to these sub-prime mortgages are they have stopped lending to each other. If they do lend to each other it is at a much higher rate.
This is why this crisis is so serious. Economies need credit, without it they stop functioning well. Many companies roll over their debt (replace old debt with new). When they can't get new loans because banks are afraid to loan money (hoarding cash in case they get into trouble, they need by regulation a certain amount of capital) they must cut costs.
When individuals cannot get credit to purchase a new car or a new stove, then the sale of large manufactured goods plummet. Even Toyota is starting to feel the pinch of slumping sales. This in turn causes companies to lay off staff, etc..
This crisis has a ways to go yet. Next on the horizon could be credit card debt.