Despite constant efforts for the last one year, the FED is now forced to offer a $ 700 B plan to purchase the 'toxic-debt', a term for under-performing loans mostly mortgages in different forms. Also, the size of the prime mortgages defaulting now is higher than the sub-prime mortgages.
Analyzing the problem with a bottom-up approach, the underlying cause of the problem is what I call borrower’s 'free put option'. A homebuyer in America gets a ‘free put option’ when he takes a mortgage. He can walk away from the property leaving it to the bank, as the collateral is the property itself and nothing else. Most states will not allow the banks to go after the home buyer's other assets or future income.
Further, banks now are offering short-sale opportunities where even the credit-histories of home owners are not affected.
In the last decline of real estate market, in the early 90s, borrowers displayed patience thru the downturn and did not use these options, probably because their down-payment was higher at that time.
If the decline in home prices continues, more homeowners – even those who can afford to make payments - would like to use the option, thereby increasing the size of the 'toxic-debt', creating a vicious cycle.
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