Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Subprime loans

In many ways the traditional approach was a good model, except that it excluded large numbers of people – basically everyone with a less-than-perfect credit record. This group was a huge and potentially very profitable untapped market. Soon banks thought to themselves: ‘you know what, maybe we can lend to these guys. They’re riskier than our usual customers, but that’s okay because we’ll charge a higher interest rate to compensate us for the additional risk.’

These higher risk loans came to be known as subprime loans, because

they were riskier than the old ‘prime’ loans. Subprime loans led to a large increase in the pool of potential borrowers. Whereas in the past perhaps only two interested buyers for a property could raise the required funds, now maybe ten interested buyers could, all with access to credit. In response to this massive increase in demand, the inevitable happened: property prices skyrocketed (for example, in Miami between 2002-06 the price of an average house doubled!).

As prices continued to rise year-on-year people started to believe that property was a one-way bet – that it would always increase in value and never decrease. Speculators with no intention of ever living in (or even renting out) their houses bought property in the hope that prices would continue to rise.

Banks weren’t immune from this optimism either, which led many to relax their lending rules so even more people became eligible for home loans. To understand why, consider that in order to limit a bank’s losses in case of a borrower defaulting, the loan contract says that if the borrower is unable to keep up with his repayments, the bank can repossess the property. In other words, if you don’t repay the loan, the bank can take the property and sell it in order to cover its losses.

Now, usually before a bank gives you a mortgage, it demands a substantial deposit (say 20 per cent of the value of the property). Then if house prices fall by 20 per cent and at the same time you default on the loan, the bank is able to recover most of the money it lent out. But if banks become very optimistic and think that house prices won’t fall, they don’t need to ask for a deposit! They began asking for smaller and smaller deposits: 15 per cent, 10 per cent and then 5 per cent.

Eventually, many banks were willing to lend without the need for any deposit at all; some banks were so optimistic they were even willing to lend more money than the total value of the property! Loans of 110 or even 120 per cent of the value of the property weren’t unheard of. Unsurprisingly, consumers lapped up these loans.

Banks that had made large loans without requiring decent deposits were now heavily exposed to the property market. If house prices fell substantially and people stopped paying their mortgages, these banks would suffer substantial losses. They weren’t worried, though: banks, like almost everyone else, thought houses were, well, as safe as houses.


They were wrong – 2006 saw the start of a massive slump in property

prices in the US. Over the next few years, prices fell by almost one-third.