Comment by thaumasiotes

Sure, bank failure might happen. That comes out clearly in the chart; the flow of value is that the bank loses a bunch of cash which ends up in "hookers".

> But to an approximation declaring bankruptcy involves losing all of your remaining assets. So in that scenario the borrower is on the hook for the cost of replacing those assets (limited by how far underwater they were on the mortgage naturally).

If you financed something by borrowing against your house, then it cost less than your house, and when you have to replace it, the cost will be less than the cost of buying a house at the original prices. This is the "you lose your house and your car" example. Losing your mortgaged house and your owned-free-and-clear car is good when buying a replacement house+car costs less than the mortgage on your house.

What if house prices fall into the sweet spot where (1) your mortgage is underwater; and (2) a new house + new "assets" exceed the value of your mortgage? (But don't exceed the original value of your house.)

It could be that those assets don't generate income. In this case, they are isomorphic to the hookers in the example.

If they do generate income, then you might save money by keeping your house at its inflated pre-crash price, and you'll make those pre-crash loan payments using the income stream generated by the assets. Here you have a loan that is nominally against your house but actually against your business. It's underwater when considered as a mortgage, but it's not underwater when considered as a business loan, so you'll keep paying it. Your bank will be fine with this. (Both in the sense that they won't object, and also in the sense that they won't suffer financial hardship.) You'll probably have to recollateralize the loan.

(Or your assets might generate income, but not enough income that you'd save money by keeping your original mortgage. In this case it's straightforward that you're better off losing the original house, losing the original assets, buying a new house, and then not buying new assets.)