What triggered the 2007-2008 financial crisis?
I have not previously heard of this but it does have explanatory power. I should have guessed that government bungling lay behind it. We all knew that the pricking of the housing bubble lay behind the financial collapse but what pricked the housing bubble? The bubble peaked in 2006 and in 2007 the trouble started, building up to the collapse of Bear Stearns, Merrill Lynch, Lehman Bros. and AIG in 2008
In 2005, Americans who racked up an inconceivable amount of credit card debt realized they could file for bankruptcy to relieve themselves of any obligation to pay back debts.
There were those who exploited the system, of course, spending excessive amounts of money on credit cards, and then filing for bankruptcy the moment any bank started asking questions.
Banks wanted protection from this sort of abuse, so they lobbied for the Bankruptcy Abuse Prevention and Consumer Protection Act which made it costly to actually file for bankruptcy.
Everything was great, and smooth sailing after that, right? Nope.
Turns out that there were people who were actually, you know, bankrupt. The new law made it to where a large number of people didn't have the money to even file for bankruptcy. As a result, these people had to default on all their debts, including their mortgages, which the banks had to foreclose.
So, now we have a situation in which all the banks have a bunch of houses they can't do anything with. What are they going to do with houses? Well, they need to sell them, of course.
As it would turn out, though, all the banks simultaneously realized that the housing market was being flooded with houses from other banks doing the same thing. Because of supply and demand, housing prices plummeted, causing even more people to default on their mortgages.
This also meant that the value of mortgage-backed securities dropped precipitously as well, leading to more than $40 billion of writedowns for U.S. financial institutions.
Banks lost so much money that they themselves began filing for bankruptcy, including one of the prominent banks that lobbied for the law in the first place, Washington Mutual. Nearly everyone lobbying for the law was subsequently punished: Citigroup Chief Executive Officer Charles O. "Chuck" Prince stepped down after losing $11 billion of writedowns on top of more than $6 billion in the third quarter of that year. Stan O'Neal was ousted as CEO of Merrill Lynch & Co., the world's largest brokerage, after an $8.4 billion writedown. Morgan Stanley, the second-biggest securities firm, had subprime losses that cut fourth-quarter earnings that year by $2.5 billion...
Posted by John J. Ray (M.A.; Ph.D.).