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For the purposes of this answer, I will assume that you are asking about the lending practices of banks at the time of the housing bubble of the early to mid-2000s. During this period, there were two main reasons why banks continued to lend in this way.
First, they believed that they could make money in this way. They may have realized that some of the people to whom they were selling loans would not be able to repay the loans. However, they would have believed that the great majority of the people would manage to, in some way, pay the loans back. In addition, any foreclosures could simply be resold without much trouble. In this way, they felt that the risks were likely to be outweighed by the potential gains.
Second, and relatedly, the banks did not realize that the housing bubble was going to burst. Very few people did realize this. The banks would therefore have thought that the vast majority of the loans would be paid back. They would have felt that house prices would continue to rise and that borrowers would not, therefore, end up “underwater.”
The banks, then, were largely caught up in the housing bubble. They believed that house prices would continue to rise and that the loans would not go bad.
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