Why can't the buyer rent back the house from the new buyer legally if it was a short sale... how can they tell the new buyer who he can rent to.

Is the lender which approved the short sale fiancing the loan to the buyers? If so, they can condition the new mortgage on a lot of things including:

no renting out the house; or
no renting to the previous borrowers.

Is that what's happening?

Yes... Wells Fargo Freddie Mac Short Sale Affidavit...

To keep a friend or family member from buying the house for the sole purpose of the benefit of the previous owner, it used to be a common fraud, the previous own has someone do a short sale buy, thus reducing greatly the money owned, the old owner then buys or contracts the home or rents it.

The short sale can not benefit the previous owner

So I guess the question is why would it matter as long as the bank is selling it for current market value to the new buyer? They are renting out to a tenant at current market value. The house doesn't get foreclosed and the bank get's a toxic assett off their books and in the mean time the investor makes money and the old owner has somewhere to live as long as they can pay the rent. Who loses here? Not the bank

So I guess the question is why would it matter as long as the bank is selling it for current market value to the new buyer? They are renting out to a tenant at current market value. The house doesn't get foreclosed and the bank get's a toxic assett off of their books and in the mean time the investor makes money and the old owner has somewhere to live as long as they can pay the rent. Who loses here? Not the bank

Or for that matter, why shouldn't the bank write-off the difference between the amount owed and the FMV, and let you keep it? Answer is that they don't want to.

I guess the reasoning goes is that it was you who made the bad investment, not the bank.

But actually, it's a very good question. I guess it comes down to who has the bargaining power.

And another reason is that the borrower, not the bank, wasn't able to keep his/her end of the bargain. So why should the bank make a new deal with the borrower who couldn't keep his/her first promise?

Exactly... I know it is an unrealistic request from the banking system to actual be logical and or understanding about this type of issue...

Is it a better idea to mess up peoples credit even worse?. therefore prolonging ability to recover financially and be worthy borrowers again...

I guess the banks seem to think that is better business to do it this way. Very frustrating.