It is crazy. People get houses they cannot afford with an ARM that is 1% or 2% now, and they just pay interest, not principle, for five years, then it goes up to market interest rates. If banks would stop loaning people money to buy a house they can't afford, then home prices would have to come back down to normal in Calif. In Texas we always had to make four times our monthly mortgage payment, P & I, property taxes, insurance, etc. So you don't get stuck there with a mortgage you can't afford.
Unless they refinance, and most people make more money after five years.
If it was just the little guy that got screwed when RE prices fall, none of the bigwigs would give a hoot.
A falling RE market doesn't affect the folks who have almost zero equity, but it hurts the big boys - the banks - and hurts them bad.
Here is the problem.
Regulators are issuing a "warning" which translates into banks cutting back on these types of loans. Since the vast majority of these loans are made in "hot markets" such as California, Arizona and Florida, the demand for housing will fall. Since the demand for housing seems to be falling anyway, the regulators are making problem worse. OF COURSE.
Plus, as ex-Texan will verify, mortgage fraud is particularly rampant in the exotic mortgage market as well. Why? Because it appeals to people who can't really afford a normal mortgage and may be desperate.
The fraud problem hits both borrowers and lenders (lenders as in major banks - the frauds are made by smaller lenders, some mortgage brokers, mortgage servicers). The default problem really causes problems for banks, Fannie and Freddie, NOT consumers.
Average houses probably wouldn't fall that far, but dumps would be priced like dumps again instead of being run up to ridiculous levels. That's the signature feature of the California real estate market these days - there is no low end any more.