I’d like to understand the situation as well. Following the OP’s lead of not really knowing but thinking it’s along the lines of…(fight my ignorance, please)
A certain percentage of borrowers will default, even in the best of times. The bank usually doesn’t take a total bath, though.
If the borrower paid into the home for awhile, say for 5 years, when the lender sells the house, the lender will get most or all the money back even if it sells for less than it’s worth. The difference just comes out of equity that the owner had built up.
The real estate market will absorb some foreclosures. When there are lots and lots of them, however, it drives prices down due to supply and demand. So lenders sold the home and lost money, or maybe it sat on the market forever, tying up their assets.
While it’s tempting to think that only a bunch of fat cat CEOs got burned, it goes deeper than that. Investment groups, retirement funds, and John Q Public also had stock in the lenders and when that stock took a beating, those who had invested when the stock was devalued also lost big.
There are people with money to lend. Some small fry put it into a CD for a year; some high rollers (e.g. a doctor) may have $250,000 they can lend for 10 years. The various banking institutions do some math and use each for various purposes. Some goes into car loans; somewhat secure, because they can usually repo the car if they have to—fairly short-term, moderate return. Some goes into credit cards; risky but profitable if you get it back. And of course, the home loan.
20 or 30 years of interest…sounds great. Should be secure—the house is the collateral, and they screen applicants to be reasonably sure they can pay.
And the last bit is where they fell down: the overvalued house didn’t necessarily reflect what was borrowed on it, so selling it off wouldn’t satisfy the debt. And the lenders, driven by greed, had lent money to people who couldn’t pay. Some bought in with an Adjustable Rate Mortgage, and when interest rates climbed, a 1% rate increase might have killed them. This involves compound interest and as my h.s. economics teacher said, "It’s called ‘amortizing’ because the debt dies so slowly.’ So they were already upside down on the home and had built no equity when it came time to refinance.
The greater issue, which I can’t quite verbalize, seems to be that we’re a debtor nation. I own a house and a car. Well, no, I don’t, but I’m paying on the loans so I “own” them. But when credit is tight, fewer people can buy. Next thing you know, Bob down at the Honda dealer and Rick over at ReMax can’t sell, so they’re out jobs.
The trickle effect builds into a ripple from there because people stop spending according to fear. Now I can’t retire for another 75 years because my retirement fund took a beating. No more of this dining at the Golden Arches Country Club, stuff…I have to save bones and make soup. People stop buying, which puts the people who produce the goods and services out of business.
And corporations can’t generate capital by selling stock if people shy away from the markets, due to the malfeasance or stupidity of those who burned stockholders who came before them.
Not a good scenario for a debtor nation’s economic growth and prosperity.
I wonder what it will do to the value of the dollar overseas: I got nothing.