Recently, there has been a lot of press coverage (in between clips of Paris Hilton going to jail) about something called subprime lending. I’d like to explain what the current problem is to aid anyone trying to better understand the articles about it.

There is one basic banking idea you should understand for this post: the most common way banks make money is by charging people interest on loans, credit cards, mortgages, etc. The interest that they charge depends a lot on how comfortable they are with whether or not you will be able to pay back the loan. The more risk you have, the higher the interest.

So, about 10 years ago, banks started to feel pressure from their owners to be more profitable. In order to do that, the bank had to either charge more interest on loans or find more customers to apply for loans. Some banks chose the latter, and began to take on riskier customers. These customers are known as ‘subprime’ customers, because their credit ratings are not the greatest. These subprime loans typically had low interest rates at first and were attractive to people with low credit scores (indeed, low interest rates are attractive to anyone regardless of credit rating). But the banks still consider these customers risky, so they charged higher interest rates. Nothing unusual here, except that many banks fully expected customers to default on the loans. Real estate prices were rising so the bank could either make money when the customer paid back the loan, or they could make money by foreclosing on their house and selling it. They were making money coming and going: both money from the customer until he defaulted and money from the sale of his house too.

If a bank knew that a borrower was going to be unable to repay his loan but lent him the money anyway, the bank would be guilty of what’s called ‘predatory lending’. This is something that is forbidden by law. In fact, there is a federal investigation going on to determine if any laws were broken.

So why so much press coverage? Because hundreds of thousands of people are facing foreclosure on their homes.

You can read more about this on the wikipedia article: http://en.wikipedia.org/wiki/Subprime_meltdown.