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

Ana Fostel and John Geanakoplos ()
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John Geanakoplos: Cowles Foundation, Yale University, http://economics.yale.edu/people/john-geanakoplos

No 1809R, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

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 afterwards. 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.

Keywords: Financial innovation; Endogenous leverage; Collateral equilibrium; CDS; Tranching and asset prices (search for similar items in EconPapers)
JEL-codes: D52 D53 E44 G01 G10 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-bec, nep-cba and nep-fmk
Date: 2011-08
Note: CFP 1353
References: View references in EconPapers View complete reference list from CitEc
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Published in American Economic Journal: Macroeconomics (January 2012), 4(1): 190-225

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http://cowles.yale.edu/sites/default/files/files/pub/d18/d1809-r.pdf (application/pdf)

Related works:
Journal Article: Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2012) 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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