The fundamental problem is that mortgage credit has been extended to people whose history shows that they do not take seriously the obligation to repay and/or pay interest on money that has been loaned to them, on a timely basis.

In many cases, these people have committed fraud to obtain mortgage credit, either by lying about their ability to repay or by having no intention of repaying the loan.

The lenders relied on the fact that the continued supply of credit was driving up the value of their collateral, so that they would be paid regardless of the bad faith or inability of the borrower.

Eventually, the supply of new housing exceeded the supply of credit. Prices came under pressure and lenders could no longer look to the appreciation of the collateral to bail them out. The rate of defaults rapidly became intolerable when recovery from collateral didn’t work anymore, and lenders have started dropping like flies.

Outstanding credit will now shrink as new loans are issued at a lower rate than defaults. The price of housing is already declining, and the declines will accelerate. We saw yesterday that builders are still starting new houses at a rate twice that of sales. Not a sustainable situation, they will have to dump their inventories at fire sale prices.

Property owners will no longer be able to continuously ramp up their borrowings based on appreciation. This will reduce their spending and consumption and the economy (as measured by GNP/GDP) will shrink. The only question is how deep the recession will be, and whether it will turn into depression.