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

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  • Emine Boz
  • Enrique G. Mendoza

Abstract

Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors 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 overly optimistic about the persistence probability of a high-leverage regime. Conversely, the first realization of a low-leverage state turns agents unduly pessimistic about future credit prospects. These effects interact with the Fisherian deflation mechanism, resulting in changes in debt, leverage, and asset prices larger than predicted under either rational expectations without learning or with learning but without Fisherian deflation. The model predicts a large, sustained increase in net household debt and in residential land prices between 1997 and 2006, followed by a sharp collapse in 2007.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16020.

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Date of creation: May 2010
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Handle: RePEc:nbr:nberwo:16020

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As found by EconAcademics.org, the blog aggregator for Economics research:
  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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Cited by:
  1. Pei Kuang, 2013. "Imperfect Knowledge about Asset Prices and Credit Cycles," CDMA Working Paper Series 201303, Centre for Dynamic Macroeconomic Analysis.
  2. Patrick A. Pintus & Jacek Suda, 2014. "Learning Financial Shocks and the Great Recession," Working Papers halshs-00830480, HAL.
  3. Enrique G. Mendoza & Marco E. Terrones, 2012. "An Anatomy of Credits Booms and their Demise," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 15(2), pages 04-32, August.
  4. Sudipto Bhattacharya & Charles Goodhart & Dimitrios Tsomocos & Alexandros Vardoulakis, 2011. "Minsky’s Financial Instability Hypothesis and the Leverage Cycle," FMG Special Papers sp202, Financial Markets Group.
  5. Pintus, P. A. & Suda, J., 2013. "Learning Leverage Shocks and the Great Recession," Working papers 440, Banque de France.
  6. Vincenzo Quadrini, 2011. "Financial frictions in macroeconomic fluctations," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 209-254.
  7. Stijn Van Nieuwerburgh, 2012. "The Research Agenda: Stijn Van Nieuwerburgh on Housing and the Macroeconomy," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 13(2), April.
  8. Alejandro Justiniano & Giorgio E. Primiceri & Andrea Tambalotti, 2013. "Household Leveraging and Deleveraging," NBER Working Papers 18941, National Bureau of Economic Research, Inc.
  9. repec:fip:fedreq:y:2011:i:3q:p:209-254:n:vol.97no.3 is not listed on IDEAS

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