The primary innovation of the secondary mortgage market in the US is that
risk of default is borne by investors who are many steps removed from borrowers. Traditionally in the US, home mortgages were kept by the local bank (as most are still in the UK). If a borrower defaulted, it was the bank that suffered. Therefore, the bank had the incentive to only make loans to creditworthy borrowers. Today, with an active secondary mortgage market, US lenders are able to "securitise" or sell their customers' loans to investors. This, in turn, frees up the lender's capital to make more loans. However, the danger is that there are no longer any "gate keepers" along the securitisation pathway who have an incentive to shut the door on uneconomic loans.
As a result, mortgage lenders in the States continued to extend loans to ever-more-marginal borrowers because there was a ready party in the secondary market willing to pay a high price for those loans. At best, the debt-rating agencies relied on false information provided by borrowers, which caused them to incorrectly rate packages of mortgage loans. At worst, the agencies perhaps compromised their institutional integrity to earn the resulting fee that came along with an adequate debt rating. Indeed, at the Morningstar Investment Conference in London, Keith Anderson, BlackRock's CIO for fixed interest noted that Moody's was nearly shut out of a key part of the credit-ratings market when it tightened up its ratings standards. Hedge fund managers, who levered up to purchase the mortgage-backed securities, were simply hoping to make it to Dec. 31 and collect a hefty, non-refundable incentive fee. The parties left holding the bag, the investors who ultimately owned the mortgage-backed securities, were too blinded in their quest for yield to ask if the extra 200 basis points of income was really worth the risk.
Once the underlying mortgages began performing poorly, the prices of the mortgage-backed securities declined. These securities often served as collateral for hedge funds' margin loans, so as prices declined, brokers demanded more collateral. If the fund was unable to meet the margin call, the securities would be involuntarily liquidated, leading to further price declines that sent more funds head-first into the vicious margin call cycle. After a few high-profile fund disasters, skittish investors began to withdraw capital from all funds with mortgage exposure leading to more liquidations and driving down prices even further. In the midst of it all, credit dried up as financial institutions began to fear the extent of the crisis.
Northern Rock was at the receiving end of the credit crunch. Most lenders in the UK operate by lending out the assets they hold for savers and earning a spread on the interest rate they pay savers versus the higher rate they charge borrowers for use of the assets. Northern Rock worked differently, however--it funded the vast majority of its loans by borrowing from other institutions. Thus, when credit markets seized up and Northern Rock was unable to borrow at rates that made economic sense, it could no longer fund new loans, essentially shutting down its ability to continue writing new business.
The tightening of credit certainly causes many problems in the short term, but this too shall pass. Markets correct mistakes by destroying misallocated capital, and we're certainly witnessing that now. But it should at least shake out flaws in the regulatory and credit ratings systems, and five years hence, the City and their Wall Street counterparts will have something new to worry about.