American Dream's Harsh New Reality

Shiller's recent field studies in San Francisco and Los Angeles showed that many homebuyers and owners are still expecting annual median housing price increases of 5% for the next 10 years. A similar trend is occurring in Boston.

"People still have sanguine expectations. They won't default as long as expectations hold up," Shiller says.

The foreclosures aren't just hurting real estate investors who sought to make a quick buck flipping houses. According to the Mortgage Bankers Association, only about 16% of prime loans in the U.S. that are defaulting were for investor houses, or houses whose owners do not live in them. About 12% of subprime loans in default were to these speculators.

Investor loans, though, were a major driver of the defaults in Nevada, Arizona, Florida and California. These four states faced the fastest increase in delinquent loans in the first half of 2007.

In Nevada, the worst market from a default standpoint, about 32% of prime loans that are defaulting and 24% of subprime loans defaulting were those held by such investors.

Preventable Pain

Of course, nearly 2 million foreclosures over the next two years represents only about 1.8% of all U.S. households. What is particularly troublesome, however, is that much of this fiasco could have been prevented.

"The entire debacle you are observing -- there is nothing unexpected about it. It is astonishing to me that people were unprepared, " says Michael Bykhovsky, founder and CEO of Applied Financial Technology, a division of Fidelity National Information Services(FIS Quote) that provides mortgage default models for banks and other institutions.

To justify the pricing on many of the subprime loans originated in recent years, lenders had to assume that home prices would increase 10% to 15% a year, Bykhovsky says. The people who originated these loans were either gambling with institutional money and expected this trend to continue, or they had faulty models, he says.

If they had performed even a minimal amount of analysis, he says, they would have found that "the gamble is not only risky, it is almost highly likely to lead to where we are now.

"In most cases," he says, "the extent of incompetence is mind-boggling."