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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 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.
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  • Ana Fostel & John Geanakoplos, 2011. "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," Levine's Working Paper Archive 786969000000000192, David K. Levine.
    • Handle: RePEc:cla:levarc:786969000000000192
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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