To sell more profitable subprime mortgages, mortgage companies bundled the debt into consolidation packages and sold the debt on to other finance companies. In other words, mortgage companies borrowed to be able to lend mortgages. For example, the lending was not financed out of saving accounts (Mortgage Guide).
These mortgage debts were bought by financial intermediaries. The idea was to spread the risk, but, actually it just spread the problem. Usually subprime mortgages would have a high risk assessment rating. But, when the mortgage bundles got passed onto other lenders, rating agencies gave these risky subprime mortgages a low risk rating. Therefore, the financial system denied the extent of risk in their balance sheets (Mortgage Guide).
Many of these mortgages charged a balloon interest rate in which, they charge low interest rates in the initial period, but at the end of the introductory period interest rates rise rapidly (Mortgage Guide).
In 2007, the US had to increase interest rates because of inflation (BBC). This made mortgage payments more expensive. Furthermore, many homeowners who had taken out mortgages two years earlier now faced ballooning mortgage payments as their introductory period ended. Homeowners also faced lower disposable income because of rising health care costs, rising petrol prices and rising food prices.
This caused This caused a rise in mortgage defaults, as many new homeowners could not afford mortgage payments. These defaults also signaled the end of the US housing boom. US house prices started to fall and this caused more mortgage problems. For example, people with 100% mortgages now faced negative equity (Mortgage Guide). It also meant that the loans were no longer secured. If people did default, the bank couldn't guarantee to recoup the initial loan.
The number of defaults caused many medium sized US mortgage companies to go bankrupt. However, the losses weren't confined to mortgage lenders, many banks also lost billions of pounds in the bad mortgage debt they had bought off US mortgage companies. Banks had to write off large losses and this made them reluctant to make any further lending, especially in the now dangerous subprime sector (Shah).
The result was that all around the world, it became very difficult to raise funds and borrow money. The cost of interbank lending had increased significantly. Often it was very difficult to borrow any money at all. This affected many firms who had been exposed to the subprime lending. It also affected a wide variety of firms who now have difficulty borrowing money (Shah).
The slowdown in borrowing has contributed to a slowing economy with the possibility of recession in the US and all around the world.
Credit Crunch in the UK
UK mortgage lenders did not lend so many bad mortgages. Although mortgage lending became more relaxed in the past few years, it still had more controls in place than the US. However, it caused very