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

Overinflating the housing bubble: Subprime lending

Houses are expensive. Even if you have a good job and you scrimp and save every month, by the time you’ve saved up enough to buy a house outright, retirement is likely to be knocking at your door! Most people don’t want to wait until their fifties or sixties in order to buy a property, so they commonly take out a large loan called a mortgage when they’re relatively young and pay it back over the course of their working life.

The traditional ‘prime’ mortgage

Enter the banks: they act as an intermediary between those who want to save money and those who want to borrow money. So if John inherits a large sum of money that he wants to save, and he deposits it at his local bank branch,

his bank can lend out some of that money to Jane who wants to buy a house.

This procedure is profitable for the bank, because it typically pays a low rate of interest (or none at all) on deposits and charges a relatively high rate when making loans. Part of the reason for this difference in interest rates is that John probably views the bank as a relatively safe place to keep his money. He’s confident that it’ll give his money back when he comes to withdraw it (whether he should be so confident is another matter – check out Chapter 14!).

Jane, however, seems a riskier prospect to the bank: sure, she has a good job now, but who knows whether she’ll still have it in 20 or 30 years’ time. The bank may even worry about whether Jane will still be alive at the end of the repayment period (sorry to be morbid, but banks have to take into account such real risks). To compensate it for the risk that Jane may not repay the mortgage, the bank charges a risk premium: that is, it charges her a higher interest rate. If a bank makes a large number of loans, some of which aren’t repaid, this risk premium is supposed to ensure that it still makes a healthy profit.

In ‘times of old, when knights were bold’ (well, a number of decades ago), banks were relatively risk averse – they were very careful about who they lent money to. In order to get a mortgage, you typically needed a longstanding relationship with your bank and your bank manager. The idea was that the bank knew you very well before giving you a mortgage and therefore could tell whether you were likely to repay it.