As securitization developed, it allowed financial intermediaries to provide new funds for borrowers to enter the housing market. This led to a rise in the rate of homeownership and was hailed as a positive development. But there was a dark side to this process as well.
As the housing boom began in 2002, lenders and home purchasers began to take increasing risks. Lenders made subprime loans to borrowers with limited ability to actually repay their mortgages and did not exercise full diligence in making loans. Some households were willing to take on considerable debt because they were confident they could make money in a rising housing market. Lenders securitized the subprime loans and financial firms offered exotic investment securities to investors based on these loans. Many financial institutions purchased these securities without really knowing what was inside them. Because the securities were so new, the agencies that traditionally evaluated the riskiness of these investments did not post sufficient warning.
When the housing boom stopped and borrowers stopped making payments on subprime loans, it created panic in the financial market. Not only did investors and financial firms now realize their investments were extremely risky, they began to worry about the creditworthiness of banks and other financial intermediaries that held these securities as assets. Many were highly leveraged and exposed to great risk. Effectively, through securitization the damage from the subprime loans spread to the entire financial market, causing a major crisis.