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Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes

Ana Fostel and John Geanakoplos

American Economic Journal: Macroeconomics, 2012, vol. 4, issue 1, 190-225

Abstract: We show how the timing of financial innovation might have contributed to the mortgage bubble and then to the crash of 2007-2009. We show why tranching and leverage first raised asset prices and why CDS lowered them afterward. This may seem puzzling, since it implies that creating a derivative tranche in the securitization whose payoffs are identical to the CDS will raise the underlying asset price, while the CDS outside the securitization lowers it. The resolution of the puzzle is that the CDS lowers the value of the underlying asset since it is equivalent to tranching cash. (JEL E32, E44, G01, G12, G13, G21).

JEL-codes: E32 E44 G01 G12 G13 G21 (search for similar items in EconPapers)
Date: 2012
Note: DOI: 10.1257/mac.4.1.190
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Related works:
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011) Downloads
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011) Downloads
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011) Downloads
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011) Downloads
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