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The reason housing is wreaking havoc even on insurers like AIG and big investment banks, who do not make mortgage loans, is that during the boom, trillions of dollars of mortgages were packaged together into securities that promised to pay investors with the proceeds of those loan payments. Those securities paid better rates than other types of assets during the boom years. So many investors from around the globe poured as much money as they could into those securities. Faced with this demand, lenders starting making more loans to riskier borrowers, including people who might not be able to afford their mortgage payments in the future and even many with no proof of income. When prices were rising, this wasn’t a problem. The risk of loan foreclosure or default was limited because many homeowners were able to sell their house for more than they owed and make a profit. But once prices topped out and began falling, loan defaults and foreclosures started shooting higher as homeowners found it more difficult to sell their house. This created problems not just for subprime borrowers but even for those with good credit and income.

Housing problems not solved by bailouts - Sep. 17, 2008