These loans started under-performing because many of them were taken by folks who could never afford them in the first place. The guidelines were essentially non-existent.

Prices rose in the first place, not because housing became more fundamentally affordable – incomes didn’t rise, and teaser-rate tricks only work so long – but because there was a huge influx of new buyers – fake demand. The rise in prices is what allowed each of these ‘relaxions’ in guidelines – these loans would have performed horribly from the get-go without the underlying asset price increases, which served to mask the situation.

At some point, you run out of people who could even afford the falsely-low initial rates, and then the “music stops”. Housing prices drop since nobody can get a loan. And, of course, then you’ve got classic supply-and-demand. High-risk lending is over, because these borrowers were always far too risky. Fees and higher interest rates would have to be increased so much that the ‘suicide loan’ toxic nature of these ‘products’ would prevent people from getting into them in the first place. They will revert to being renters.

Prices will correct – they will drop in real terms until they revert to the norm – though, due to overall inflation, nominative prices may not appear to decline quite as much. For some perspective though, according to HUD and OFHEO, c’ville was already 25% over-valued by 2004. Incomes didn’t increase 25% a year, driving up fundamental “affordability” the way they did during the 70s. The price increases were entirely the result of the credit bubble…and like any Ponzi Scheme, for a while, the influx of new loans, buyers and transactions will keep the bubble inflating.

I think this video does give a nice visual representation of what’s going to happen to prices and transaction volume. I have one small quibble – while it’s certainly true that folks who are prime will still experience falling asset values (their homes won’t be worth as much), they won’t be “caught” in this “debt trap” unless they opted into a toxic loan product in the first place – folks who took fixed 10, 15 or even 30 yr loans at ~35% of their documentable income, will be able to ride this out just fine.

All the while during the expansion of credit prices were also rising. So while there wasn’t a reason given for why the loans started to underperform I would suspect a big part of that was a limit on the rate at which prices could continue to rise. Then when the credit rules were tightened the prices were also a big reason why people couldn’t sell.

I’m really not holding out any hope that we’re at the bottom yet.