How did housing prices bring the market down when only eight states have foreclosure rates higher than the national average?

The way eight states bring down the economy is that the foreclosed assets were heavily leveraged: The whole country might as well have been the Golden State given that Citibank would bet $56 on every buck of California mortgages.

For every single dollar of mortgage on every home in California, Citibank had $56 wagered on the prospect that that mortgage would not go bad. On every single mortgage. The fact that it was not truly on every mortgage only makes it worse: if it was on half of California mortgages (still a massive number), it was a bet of $112 for every dollar of the mortgage.

And thanks to Phil Gramm, John McCain, and George W. Bush, it all remained unregulated, with no requirement that Citibank maintain anywhere near the cash to pay off these bets if the bank lost.

The bank lost, and we're left holding the bad debt. As Tim Duy put it:

This is not meant to imply that restarting credit markets is not a worthy effort. The opposite is true; functioning credit markets are important to economic growth...but functioning likely means a return to conventional underwriting metrics, and thus housing prices will remain depressed. Indeed, I think a good argument can be made that, under conventional norms, homes price should decrease until mortgage payments are less than the rental equivalent (after accounting for the hassles and costs of home ownership).

Policymakers are assuming that restoring proper functioning in credit markets—and confidence in general—is equivalent to a housing price rebound. They seem incapable of envisioning a world in which this is not the case. This tunnel vision prevents policymakers of trying to devise policy which assumes that the many of the assets in the banking system are simply "bad." For Bernanke and Geithner, there are no bad assets. Only misunderstood assets.

They bet that inflated housing prices would never go down. Housing prices went down, and they can't deal with it.

(Via Ezra Klein and Paul Krugman.)