This post from Mike at Rortybomb is the most lucid explanation of what banks got out of making loans to people who obviously had no chance of keeping up with their payments. As long as prices were rising, it worked out better for the banks if borrowers were subprime, fell behind on their payments, and had to refinance, paying fees and prepayment penalties to the banks.
Let’s assume that the bank thinks house prices will rise. If house prices rises 10% during that 2-year time period, the homeowner now has ~12% equity in the home, ~3.5% (4%, adjust for the new house cost) of which is transfered to the bank in form of the prepayment penalty. In addition to a high interest rate, they get a jackpot 4% every time this crap loan is recycled.
So this loan has value for the bank if housing rises, and lower value if housing decreases. Because of the quick recycling of these loans, where they refinance every two years, it is direct exposure. Instead of providing consumers with loans so they can buy homes, they are instead taking bets on house prices, using consumers as people who sit in and look after the homes they are betting on. The purpose is less to get consumers to build good equity but rather find ways to transfer equity from the home to the bank itself.
As Mike explains, the upshot of this is that banks were actually looking for bad borrowers—they weren’t forced by the Community Reinvestment Act. And the idea that the banks were performing some kind of civic service by expanding the pool of homeowners is now exposed to be the bogus alibi that it always was.
Banks are generally in the brokering business, matching investment funds to worthy investments and managing the risk associated with that to earn their keep. They aren’t supposed to be in the business of making bets themselves—their advantageous position when it comes to accessing capital comes at the cost of not putting themselves in risk’s way themselves. The sort of thing that Mike describes in the post exemplifies how banks inflated the housing bubble and expanded the percentage of the profits that went to the financial industry. We have yet to see any regulatory changes that would put a stop to it. Mike recommends reinstating the ban on prepayment penalties—that seems a good place to start.