Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis

Emine Boz and Enrique Mendoza

No 16020, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors behind the U.S. credit crisis. We show that a boom-bust cycle in debt, asset prices and consumption characterizes the equilibrium dynamics of a model with a collateral constraint in which agents learn \by observation" the true riskiness of a new financial environment. Early realizations of states with high ability to leverage assets into debt turn agents overly optimistic about the persistence probability of a high-leverage regime. Conversely, the first realization of a low-leverage state turns agents unduly pessimistic about future credit prospects. These effects interact with the Fisherian deflation mechanism, resulting in changes in debt, leverage, and asset prices larger than predicted under either rational expectations without learning or with learning but without Fisherian deflation. The model predicts a large, sustained increase in net household debt and in residential land prices between 1997 and 2006, followed by a sharp collapse in 2007.

JEL-codes: D83 E44 F41 (search for similar items in EconPapers)
Date: 2010-05
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (33)

Published as Boz, Emine & Mendoza, Enrique G., 2014. "Financial innovation, the discovery of risk, and the U.S. credit crisis," Journal of Monetary Economics, Elsevier, vol. 62(C), pages 1-22.

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Related works:
Journal Article: Financial innovation, the discovery of risk, and the U.S. credit crisis (2014)
Working Paper: Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (2010)
Working Paper: Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (2010)
Working Paper: Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (2010)
Working Paper: Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (2009)
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