ABSTRACT

John Kenneth Galbraith's book, The Great Crash, argued that the economy on the verge of the Great Depression was so fragile that it was just waiting for some event to cause the crisis. It does not really matter what that triggering event was—it could have been anything—and we think that is also true of 2007. If one had to identify a primary weakness it was in the U.S. housing market, specifically the problem with mortgages underwritten on the basis of expected refinancing or home sales. While this was preeminent among the non-prime mortgages, prime mortgages were far from immune from this decline in the quality of underwriting. Some prime mortgages have recorded a default rate as high as that on subprime mortgages, and have recorded a rising default rate as early as subprime mortgages. Financial fragility spread to the rest of the financial system through the layering of debts promoted by securitization and derivatives. This layering of debts, combined with the poor quality of debts, made the U.S and some European countries prone to a debt deflation. Thus, while many have called the 2007 financial crisis a subprime crisis, it is more accurate to call it an underwriting crisis. Regardless of credit risk, expected repayment increasingly became dependent on a bonanza based on rising home prices and this is what made a debt deflation possible.