To reduce the risk of each individual mortgage, lenders package mortgages together and sell them on Wall Street. For example, a lender may sell a package of ten mortgages to Wall Street investors. The investors will benefit by collecting the mortgage interest. Of those ten, two may be subprime or of a higher risk level. Due to the fact that there are eight other mortgages packaged into the deal, it reduces the risk.
What has happened to many banks is that in their agreements with Wall Street investors, if there is a certain default ratio, they would need to buy back the loans. With the declining housing market, adjusting interest rates and other market factors, the default ratio has increased significantly. Wall Street investors enforced the buy back agreements which made banks buy back billions of dollars in loans. This effectively eliminated the bank’s ability lend and put them into bankruptcy.