Was the U.S. Crisis a Financial Black-Hole&quest

Romain Ranciere and Aaron Tornell

IMF Economic Review, 2011, vol. 59, issue 2, 305 pages

Abstract: This paper argues that the U.S. financial crisis is a new type of crisis: a “financial black hole.” Financial black-holes are characterized by the breaking-up of credit market discipline and the large-scale financing of negative net present value projects. In a theoretical model, the paper explains how the interaction of perceived government guarantees and the ability to issue catastrophe-bond-like liabilities generates financial black-holes. The paper then shows that key facts of the recent U.S. crisis can simultaneously be rationalized by the financial black hole equilibrium: Between 2003 and 2006, the origination of catastrophe-loan type mortgages exploded, as well as the issuance of ‘Private Label’ mortgage-backed securities that helped off-load them into the market. During the same period, there was a massive increase in the origination of mortgages to borrowers with limited repayment ability, absent a continuous increase in home prices. While this situation should have led to an upward repricing of the risk associated with Private Label MBS, the contrary occurred and the spread on these securities actually declined. While each of these facts in isolation can be interpreted differently, the strength of the financial black-hole explanation is its ability to account for the combination of these key facts.

Date: 2011
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