I understand these loans were given to the poorest parts of society and that for about the first two years the interest rate was fixed at a relatively low rate and subsequently increased hugely causing many to default. Would it not be better for the banks to reduce the interest rates to an affordable rate on all these loans, maybe extending the term and not go to the expense of foreclosing on property that seems to be pretty well worthless? And if so why are they not doing this as all these foreclosures result in all property being devalued (Cleveland, Ohio) and more people defaulting and creating a crisis in banking. Is this too simplistic?
Yes.
The banks packaged up the loans and sold them on in the form of mortgage backed securities. The banks retained a portion of the revenue for themselves as servicers of the mortgage.
The banks then recognised the revenue from the servicing and the bond sales.
So to reduce the interest rate, the banks would have to get agreement of the bondholders and recognise the revenue loss to previously booked profits.
To complicate matters, mortgages were vertically sliced, so that a bit of each mortgage went into different MBS, that were sold to different investors.
Calling it a mess doesn't begin to describe it.
By the way, it wasn't just poor people who took out adjustable rate mortgages, just about everyone did it. And not just in America, in the UK, Spain and Ireland. Think to yourself, what is an adjustable rate mortgage? It's a fixed period at one interest rate that resets to a different variable rate once the fixed period is up. Know anyone in Ireland who took out a 2 year fixed when rates were 2ish percent? They are currently getting their new rates at double the old one. If they don't have enough equity in their house because the took out a 100% mortgage or because the price of their house has fallen or because they have been paying interest only for the first two year or because of all three, they won't be able to refinance with another lender offering a discount rate or a low rate based on LTV. So they will be a bit stuffed.
Mostly the problem has been that people in the US bought houses when interest rates were low at prices they couldn't afford when interest rates returned to a normal level. There is an element of fraud involved, but until recently people weren't walking away from their houses simply because of negative equity. However, in the last quarter of last year this started to happen and people (I have a terrible temptation to call them folks, but then that would be calling them terrorists!) began to walk away simply because the transaction of owning a house did not make business sense. If you are in negative equity and your interest rate is resetting, it does not make economic sense to struggle with the payments. Walk away, suffer the bad credit rating, rent for a few years until your rating improves and save yourself a packet. Companies do it all the time when they walk away from deals (look at chapter 11 bankruptcy in the US sometime).