Here’s what happened: in the irrational exuberance of the housing bubble, many people were allowed/encouraged/suckered into buying houses with very little money down, at prices much higher than justified by fundamental. Now the prices are coming back to earth, and many of these people find themselves owning houses worth considerably less than their mortgages.
This leads to both involuntary and voluntary foreclosure. Involuntary foreclosure comes when people who thought they could deal with unaffordable mortgage payments by refinancing find that you can’t refinance when your home is worth less than you owe.
Voluntary foreclosure comes when people simply walk away, either because the mortgage is “nonrecourse” — the bank can seize the house, but no more — or because they figure, probably correctly, that the bank won’t really try to pursue them.
Hal Varian (Berkeley prof and now chief economist at Google) puts it simply, and in somewhat exaggerated form, by saying that everyone will just default on their existing mortgage and move one house to the left, buying a new house for less than they save by walking away from the mortgage they have. Things don’t work that smoothly, but that gets the principle right.
And what that means is that a substantial portion of the decline in housing values that’s now in progress will eventually show up as losses, not to homeowners, but to investors. We’re talking about some significant fraction of, say, $6 trillion (a 30% decline in home values from their peak). A trillion dollars in investor losses sounds quite reasonable.
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