IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

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

  • Ana Fostel
  • John Geanakoplos

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).

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.aeaweb.org/articles.php?doi=10.1257/mac.4.1.190
Download Restriction: no

File URL: http://www.aeaweb.org/aej/mac/data/2011-0037_data.zip
Download Restriction: Access to full text is restricted to AEA members and institutional subscribers.

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

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

as
in new window

Handle: RePEc:aea:aejmac:v:4:y:2012:i:1:p:190-225
Note: DOI: 10.1257/mac.4.1.190
Contact details of provider: Web page: https://www.aeaweb.org/aej-macroEmail:


More information through EDIRC

Order Information: Web: https://www.aeaweb.org/subscribe.html

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Araújo, Aloísio & Kubler, Felix & Schommer, Susan, 2012. "Regulating collateral-requirements when markets are incomplete," Journal of Economic Theory, Elsevier, vol. 147(2), pages 450-476.
  2. Gary B. Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," NBER Working Papers 15223, National Bureau of Economic Research, Inc.
  3. Viral V. Acharya & S. Viswanathan, 2011. "Leverage, Moral Hazard, and Liquidity," Journal of Finance, American Finance Association, vol. 66(1), pages 99-138, 02.
  4. Patrick Bolton & Martin Oehmke, 2011. "Credit Default Swaps and the Empty Creditor Problem," Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2617-2655.
  5. John Geanakoplos, 2010. "The Leverage Cycle," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 1-65 National Bureau of Economic Research, Inc.
  6. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  7. Ana Fostel & John Geanakoplos, 2010. "Why Does Bad News Increase Volatility and Decrease Leverage?," IMF Working Papers 10/206, International Monetary Fund.
  8. Denis Gromb & Dimitri Vayanos, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," LSE Research Online Documents on Economics 448, London School of Economics and Political Science, LSE Library.
  9. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  10. repec:cup:cbooks:9780521818728 is not listed on IDEAS
  11. repec:cup:cbooks:9780521524131 is not listed on IDEAS
  12. repec:cup:cbooks:9780521524124 is not listed on IDEAS
  13. repec:cup:cbooks:9780521818735 is not listed on IDEAS
  14. John Geanakoplos, 2010. "Solving the present crisis and managing the leverage cycle," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 101-131.
  15. Markus K. Brunnermeier, 2008. "Deciphering the Liquidity and Credit Crunch 2007-08," NBER Working Papers 14612, National Bureau of Economic Research, Inc.
  16. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
  17. Nicolae G�rleanu & Lasse Heje Pedersen, 2011. "Margin-based Asset Pricing and Deviations from the Law of One Price," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 1980-2022.
  18. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
  19. Ana Fostel & John Geanakoplos, 2011. "Endogenous Leverage: VaR and Beyond," Cowles Foundation Discussion Papers 1800, Cowles Foundation for Research in Economics, Yale University.
  20. repec:cup:cbooks:9780521818742 is not listed on IDEAS
  21. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.
  22. John Geanakoplos, 2010. "Solving the Present Crisis and Managing the Leverage Cycle," Cowles Foundation Discussion Papers 1751, Cowles Foundation for Research in Economics, Yale University.
  23. repec:cup:cbooks:9780521524117 is not listed on IDEAS
Full references (including those not matched with items on IDEAS)

This item is featured on the following reading lists or Wikipedia pages:

  1. Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (AEJ:MA 2012) in ReplicationWiki

When requesting a correction, please mention this item's handle: RePEc:aea:aejmac:v:4:y:2012:i:1:p:190-225. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Jane Voros)

or (Michael P. Albert)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.