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

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  • Ana Fostel
  • John Geanakoplos

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).

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 4 (2012)
Issue (Month): 1 (January)
Pages: 190-225

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Handle: RePEc:aea:aejmac:v:4:y:2012:i:1:p:190-225

Note: DOI: 10.1257/mac.4.1.190
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  1. Dewatripont,Mathias & Hansen,Lars Peter & Turnovsky,Stephen J. (ed.), 2003. "Advances in Economics and Econometrics," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521818735.
  2. Gary Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," Yale School of Management Working Papers, Yale School of Management amz2358, Yale School of Management, revised 01 Sep 2009.
  3. Fostel, Ana & Geanakoplos, John, 2012. "Why does bad news increase volatility and decrease leverage?," Journal of Economic Theory, Elsevier, Elsevier, vol. 147(2), pages 501-525.
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  7. Patrick Bolton & Martin Oehmke, 2010. "Credit Default Swaps and the Empty Creditor Problem," NBER Working Papers 15999, National Bureau of Economic Research, Inc.
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  10. John Geanakoplos, 2010. "Solving the Present Crisis and Managing the Leverage Cycle," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1751, Cowles Foundation for Research in Economics, Yale University.
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  17. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, American Economic Association, vol. 98(4), pages 1211-44, September.
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  19. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.
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Cited by:
  1. Guillermo A. Calvo, 2012. "The Price Theory of Money, Prospero's Liquidity Trap, and Sudden Stop: Back to Basics and Back," NBER Working Papers 18285, National Bureau of Economic Research, Inc.
  2. Christoph Basten & Cathérine Koch, 2014. "The causal effect of house prices on mortgage demand and mortgage supply," ECON - Working Papers, Department of Economics - University of Zurich 140, Department of Economics - University of Zurich.
  3. Ana Fostel & John Geanakoplos, 2013. "Financial Innovation, Collateral and Investment," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1903, Cowles Foundation for Research in Economics, Yale University.
  4. Stijn Claessens & Laura E. Kodres, 2014. "The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions," IMF Working Papers 14/46, International Monetary Fund.
  5. Giorgia Palladini & Richard Portes, 2011. "Sovereign CDS and Bond Pricing Dynamics in the Euro-area," NBER Working Papers 17586, National Bureau of Economic Research, Inc.
  6. Michael Magill & Martine Quinzii, 2014. "Prices and Investment with Collateral and Default," Working Papers, University of California, Davis, Department of Economics 143, University of California, Davis, Department of Economics.
  7. Ana Fostel & John Geanakoplos, 2013. "Financial Innovation, Collateral and Investment," Levine's Working Paper Archive 786969000000000750, David K. Levine.
  8. Ana Fostel & John Geanakoplos, 2012. "Leverage and Default in Binomial Economies: A Complete Characterization," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1877R, Cowles Foundation for Research in Economics, Yale University, revised Jul 2013.

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