Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?

A "haircut" is the difference between the value of a loan and the collateral that is put up for it. For example, suppose a bank required 102 million's worth of mortgage-backed securities as collateral for a 100 million loan. The haircut is 2%.

Due to lenders' fear that borrowers will not repay them, haircuts on collateral increase sharply during a financial crisis. To give them an incentive to continue lending, they require more collateral to protect themselves in case of default.

Keep in mind that the larger the haircut, the less attractive are loans to potential borrowers because they would have to put up a huge amount of collateral for a loan whose value is nowhere near the cost of the collateral.

It came to a point when financial institutions had to engage in fire sells, the rapid selling of their assets to raise funds since the cost of borrowing became too high. Fire sales further lowered the price of assets and worsened the state of the economy.