Generally what happened was that two very large financial bubbles developed in Japan in the late 1980s. There was the stock market and the real estate bubble that developed simultaneously. The Bank of Japan provided a lot of liquidity and there were all of the typical bubble stories about how the world was different. Japan had developed a new type of economic system. Books like "Japan as Number One" were published and stories regularly appeared about it being inevitable that Japan would soon be the world's largest economy.  

This all caused people to abandon their traditional methods of valuation. After all, it is a new world; the old methods no longer make sense. So, the fact that the land under the Imperial Palace was as valuable as all of California or that the Nikkei hit 40,000 did not faze people. Remember, it is a new world; the old rules of valuation no longer apply.  

With liquidity flooding financial markets, banks kept lending and lending with stocks and real estate as collateral. Finally, in 1991 the Bank of Japan became concerned that things really were out of hand that this was a bubble. They decided to gradually tighten and slowly deflate to bubbles. However, what was to be a gradual process caused a panic. Quickly the bubbles burst instead of slowly deflating and lenders panicked and cut of loans.  

The bursting of the bubbles say stocks fall by 75% and real estate in many places fell by 80%. People had borrowed all the money based on unrealistic assumptions about the new world. Now their plans made no sense. They could not pay them back and most of the collateral securing the loans had evaporated with the bubble. This left Japanese Banks with massive amounts of uncollectible loans (in the neighborhood of $1 trillion). Many banks became technically insolvent. One large bank LTCB want bankrupt and was sold to a US investment firm. Many others merged to try to create viable institutions from the wreckage. It has been a long road to recovery since that point in time.  

Bubbles are dangerous things. The US went through a similar experience, although not quite as sever during the latter part of the 1990s. This time the story of the new world focused on the Internet and why the old rules did not apply. Loose credit policies by the Fed fueled the bubble, which finally burst in 2001.  

When credit flows too freely, which means that the money supply is expanding two rapidly, two things can happen. The result can be a general inflation of prices in the economy. Central banks are good spotting this problem and pulling back on the money supply. However, the alternative is that the extra money flows into a bubble which seems to be able to suck up all that loose credit, without a general inflation. Not seeing any inflation on the horizon, it is politically tough for the central bank to justify increasing interest rates. Thus, the flow of credit continues and the bubble continues to grow. Finally, the bubble becomes obvious. The central bank tightens and the whole thing falls apart.