Bad credit mortgage generally involves increases in interest rates, together with a reduction in the availability of credit. Whether bad credit mortgages cause a real economic downturn depends on the severity of the crunch and the availability of alternative sources of funds.

The low risks and added convenience that banks offered depositors were overwhelmed by the higher returns available elsewhere. Banks suffered from disintermediation – depositors’ withdrawals of funds to purchase higher-yielding mortgage securities. As savers looked for higher returns outside of banks, the flow of funds to banks fell along with the amount of funds that banks could make available for loans. Monetary policy had also become restrictive and the growth rate of mortgages fell sharply. There was not a major downturn in the economy at that time, since the funds that were being withdrawn from banks were still available through other financial institutions. However, mortgages and the housing market were affected, because at that time most mortgages originated at savings banks.

One typical pattern of bad credit mortgages is that a business expansion leads to increased demands for borrowed funds by business for fixed investment and to finance mortgage increases in inventories. Then banks find their bad credit mortgage rising on loans and they become more cautious in their lending strategies. This is particularly the case when the collateral is risky, as it is for loans to finance inventory. Businesses find it difficult to obtain loans from their usual lenders, while alternative sources of funds demand higher mortgage. They decide to cut production to reduce inventory and increase cash flow.

The effect of bad credit mortgages has usually been to reduce investment and real output. Bad credit mortgage can play an important role in the cycle of inventory investment that we described earlier, but this is not always the case.