The housing crisis has caused incredible damage to the world's financial system. Property owners have lost trillions of dollars from falling real-estate values. Trillions more in losses have come from the stock market -- losses partially derived from the resulting lack of confidence in financial institutions, which has had a huge impact on people's retirement accounts and household savings.

As big as the crisis has become, it's hard to believe how easily it all could have been prevented. By simply following an old-fashioned standard for taking out a mortgage loan, all the damage that has occurred since the first subprime mortgages defaulted may never have happened.

Staying above water
Over the years, homeowners stopped looking at their homes as an investment with both risk and reward. As long as real estate prices were going up, homeowners could treat their homes merely as conduits for a higher standard of living, accessing increasing home values through mortgage refinancing and home equity loans to scrape out every last piece of newly found equity. There was little reason to keep equity locked inside your home as a hedge against a potential future drop in home prices -- and as it turned out, there was much more incentive to take the money and run.

Moreover, banks not only supported this behavior but were rewarded for it, at least in the short term. Just look at the profits big mortgage banks generated during the boom years:

Bank

Net Income in 2006

Change From 2004

Bank of America (NYSE:BAC)

$21.1 billion

51.5%

Wells Fargo (NYSE:WFC)

$8.4 billion

20.0%

Citigroup (NYSE:C)

$21.5 billion

26.4%

Source: Capital IQ.

In the aftermath of the housing crisis, of course, all of those banks have seen those huge profits drop off substantially, turning into massive losses in the case of Citigroup. Even as the subprime portion of the mortgage market has worked its way through the system, default rates have started to rise even among more creditworthy prime mortgages. Barring a quick recovery, we could be facing a new wave of mortgage-related economic pain.

What a down payment can do
The simple fix that could have prevented much of the problem would have been for lenders to require a 20% down payment to buy a home. That would have had several positive effects:

  • Fewer potential homebuyers would have qualified for mortgages, keeping housing demand down and dampening some of the upward pressure that pushed home prices to unsustainable levels.
  • Those homebuyers that did qualify would have had a huge incentive not to default on their mortgages. Conversely, with a big equity cushion, lenders would have had a margin of safety when they had to foreclose on loans that did end up in default.
  • Also, maintaining sufficient home equity would have left homeowners in a better position to refinance loans even after a substantial price drop, which has been a stumbling block against those borrowers who are in the worst trouble now.

Recent estimates affirm that as many as one in five homeowners owes more on their mortgage debt than their houses are worth -- a clear indication that homeowners didn't have enough skin in the game. Forcing buyers to come up with the tens of thousands of dollars that a 20% down payment requires wouldn't have been friendly to homebuilders like Toll Brothers (NYSE:TOL) or Pulte Homes (NYSE:PHM), but it would have been a big cushion to keep underwater mortgage levels way below that 20% figure. And while home-improvement companies like Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) might not have grown as much if new homebuyers didn’t have as much money as they did to spend on home-related purchases, they might also not have suffered the income drops they've seen in recent years.

Looking to the future
It's too late to force existing homeowners to pony up a big down payment to supplement their home equity and get their mortgages back above water. What we can do, though, is make sure we don't repeat the missteps of the past by giving people in questionable financial situations the means to buy a home that could end up overwhelming their finances.

Home ownership may be the American Dream, but when home prices are high, that collective dream isn't worth sacrificing the entire economy. Hopefully, that's a lesson we've all learned well by now.

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Fool contributor Dan Caplinger paid 20% down on his house. He doesn't own shares of the companies mentioned. The Fool's disclosure policy makes you feel right at home.