What is the root cause of the credit seize-up?

I want to ask Sean about a comment posted by him at Inman News, at an article about Heat Maps, where he stated “Unfortunately housing and foreclosures aren’t the fundamental problem, derivatives are.
There are only ~$11T in residential mortgages. We could likely reset every loan from 2004 to 2008 to 2003 values instantly resolving the foreclosure crisis for a total cost of maybe $1.5 to $2 trillion. By requiring the lenders/investors to eat half the loss, we could have used last weeks $700B to likely keep everyone in their home by giving them significant principal balance reductions and stopped the foreclosure problem completely.
But that won’t fix this. The real problem is that there is an estimated $800 Trillion in unregulated derivatives, of which $62 Trillion are credit default swaps. Those are really big numbers - and it will take more than a few hundred billion here or there to fix it.”
I believe this to be true but want more information. Can you please cite your sources? This is devastating if true. Financial Apocalypse time? How could this be addressed?
Keith Labrecque

Hi Keith - I’m a wanna-be economics grad. I definitely have spent time following a lot of the blogs you’ll find on my blog role here. Especially calculatedrisk.blogspot.com, bigpicture.typepad.com and iTulip.com.
Eric Janszen at iTulip has been especially helpful. We met in late 2005 when I asked him a question like you are asking me, but about his prediction that housing was in trouble. Keep in mind that I had been investing in foreclosures and had maybe 20 properties at the time. After a few rounds with him I was convinced to sell all of them, which turned out to be a great move as most were in Stockton, CA (now down 40-70%). Next he told me to buy gold, which I did and it went from $600-$900. Next he said the market would go down, and I bought RSW (double short the Nasdaq) at $80, and sold half last week at $189. Obviously he is a god in my books, and probably the only reason I’ve been able to finance this site without venture capital.
Eric has done an incredible amount of research on this topic, and has interviewed an amazing group of experts (some of which is reserved for his select subscribers). He often uses a lot of technical finance terms and at first it can be hard to keep up, but it is worthwhile to take the time to do so.
I’m extremely analytic, and still look for all the data points I can on these subjects - unfortunately I don’t do a good job of cataloging them as I go - Eric’s site iTulip is a great starting point and he usually references sources. Derivatives is an unfolding story that you will start to hear more about soon. The same 60 Minutes producer that did the House of Cards story that ForeclosureRadar was featured in, recently did one on derivatives. I have it Tivo’d but haven’t yet had a chance to watch - it should be on their website, and knowing the producers it should be good.
As for financial apocalypse I’m not that concerned. I believe we will see a return to affordability, less use of debt, and a continued adjustment in asset values. Like all cycles those who prepare will do well. There will be fabulous opportunities in real estate, and in my humble opinion it will be a good inflation hedge against the sea of money being printed in Washington in response to this crisis.

As an investor, my reasoning is simple.? The money that lending institutions lend out come from their?depositors (savers).? When the government keeps printing money (inflation), the?lender?needs an interest rate that will give him a decent return above the inflation rate.? Therefore if, at the same time, the government keeps the?interest rates artificially low, then money available from private sector dries up - it is as simple as that.? So now that the?politicians are?passing rules that allow bankruptcy judges to change the loan itself, thereby transferringing the borrower’s loss to the lender (saver), it is easy to foresee that it?will discourage lending even more?and the politicians?will call it “unintended consequences”.