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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 boom and then to the bust of 2007-2009. We study the effect of leverage, tranching, securitization and CDS on asset prices in a general equilibrium model with collateral. We show why tranching and leverage tend to raise asset prices and why CDS tend to lower them. 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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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 786969000000000168.

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Date of creation: 31 Jul 2011
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Handle: RePEc:cla:levarc:786969000000000168
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  12. Ana Fostel & John Geanakoplos, 2010. "Why Does Bad News Increase Volatility and Decrease Leverage?," Cowles Foundation Discussion Papers 1762RR, Cowles Foundation for Research in Economics, Yale University, revised Aug 2011.
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  24. 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.
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