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Financial innovation, the Discovery of Risk, and the U.S. Credit Crisis

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  • Enrique G. Mendoza
  • Emine Boz

Abstract

Uncertainty about the riskiness of new financial products was an important factor behind the U.S. credit crisis. We show that a boom-bust cycle in debt, asset prices and consumption characterizes the equilibrium dynamics of a model with a collateral constraint in which agents learn "by observation" the true riskiness of a new financial environment. Early realizations of states with high ability to leverage assets into debt turn agents optimistic about the persistence of a high-leverage regime. The model accounts for 69 percent of the household debt buildup and 53 percent of the rise in housing prices during 1997-2006, predicting a collapse in 2007.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 10/164.

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Length: 62
Date of creation: 01 Jul 2010
Date of revision:
Handle: RePEc:imf:imfwpa:10/164

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Keywords: Credit expansion; United States; Financial instruments; Household credit; Housing prices; Asset prices; Credit risk; Financial crisis; Economic models; financial innovation; probability; bond; probabilities; bonds; calibration; equation; markov process; optimization; financial markets; sensitivity analysis; probability distribution; standard deviation; asset markets; discounting; random variable; financial reforms; financial globalization; international finance; equations; computation; time series; discount bonds; markov processes; risk-free interest rate; financial intermediaries; probability model; stochastic discount; binomial distribution; horizontal axis; probability density function; financial statistics; integrals; international capital; financial system; commodity futures; financial sector; predictions; covariance; financial liberalization; sampling; autocorrelation; international financial statistics; functional forms; conditional expectation; stochastic model; financial derivatives; moral hazard; equilibrium solution; survey; futures contracts;

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References

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  1. Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
    by Christian Zimmermann in NEP-DGE blog on 2010-08-03 03:20:21
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