Here's how I understand the problem, which is not just that the value of the house tanked, but that the value of the mortgage tanked.
Bob bought a house for $500k from Joe, so he took out a $500k loan from Bank-A.
Bank-A offered to loan Bob $500k, at a variable interest rate, which at the time was 3%. Bank-A charged Bob a fee of 3 pts to get this great loan, which came to $15,000. Bank-A understood that over the 30 years of loan repayment, Bob would pay $258,857 in interest* if he stuck with his agreed upon monthly payment of $2108.02.
Bank-A then sells the mortgage to Bank-B. Which means Bank-B pays Bank-A $500,000 + some small percentage of the loan, lets say 3%, which comes to another $15,000.
So here's the tally so far:
Joe has $500k so he can go buy another house or something.
Bob has a house worth $500k.
Bank-A has $30,000 they didn't have last week (3% paid by Bob + 3% paid by Bank-B) minus a small amount for what it actually cost them in time and energy to type up all the papers.
Bank-B has a piece of paper they paid $515000 for, which will earn them $758,857, at present interest rates, and even more when interest rates go up. The bought the paper betting that interest rates would go up, and they were right.
Interest rates go up to 6%.
Bank-B is happy because now the piece of paper they paid $515000 for is worth $1,079,190 ($500k + 6% interest for 30 yrs)**. Bank-B is so happy they turn around and sell the mortgage to Bank-C for 6pts, which comes out to $545,900 ($515,000 + $30,900)
Bob is not happy. His payment is now $2997.75 a jump of over $800/month. It's a stretch, but he can squeak by.
Bank-C now has a piece of paper they paid $545,900 which will make them $1,079,190 at present interest rates. They are betting that interest rates will rise, and they'll make even more money.
Interest rates go up to 8%.
Bank-C is happy because now the piece of paper they paid $545,900 is worth $1,320,776.
Bob is in trouble and seriously UNhappy, because now his house payment is $3668.82 and he can't afford it anymore.
Bob wants to refinance, and try to get his payment back under 3k/month, but he can't, because the boom is over, and nobody is willing to pay $500k for a house like his anymore. The market has "corrected" itself. At most, they say, his house is now worth $300k. Nobody in the free world is willing to lend him $500k for a $300k house.
He tells Bank-C "either you get my payment under $3000/month, or you will have to foreclose.
Bank-C is now unhappy, too. The piece of paper they paid $545,900 is now pretty much worthless.
They only have a few choices. They can either
1. Foreclose, and try to sell the house themselves, which maybe will get them $250k at auction, at which point they calculate $545,900 (original cost) - $250,000 (recouped price) = a loss of $295,900. If Bank-C has 100 mortgages like this, they lose $29,5 million and 100 Bobs and Bobettes have lost their homes and ruined their credit for years.
or
2. They can refinance the $500k loan to Bob at 6% even though loans are going for 8% now. That means the value of their piece of paper that used to be worth $1,320,776 is back to only being worth $1,079,190, which means they have to "write off" a loss of $241,586.
The problem with that is that banks aren't supposed to loan out a bunch of money on mortgages without having some "real" value to back it up. So to really calculate out what the value of the mortgage is, you have to take into account the now reduced value of the house.
A new realistic loan on that same house would be $300k (the current value) at 8% (the current interest rate), which means the loan is "really" worth $300k + $492,465 in interest, which comes to $792,465. The piece of paper which last week was worth $1,320,776 is now worth $792,465, which comes out to a loss of $528,311.
If Bank-C has 100 loans like this, last week their assets were worth $132,077,600. This week their assets are worth $79,246,500. This bank just "lost" $50 million, and 100 Bobs and Bobettes are stuck with a $500k mortgage on a $300k house, so they can't sell or move (without going bankrupt) until the value of their house goes back up to around 500k, which could take decades.
