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

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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File URL: http://cowles.econ.yale.edu/P/cd/d18a/d1809.pdf
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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1809.

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Length: 47 pages
Date of creation: Jul 2011
Date of revision:
Handle: RePEc:cwl:cwldpp:1809
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  2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market liquidity and funding liquidity," LSE Research Online Documents on Economics 24478, London School of Economics and Political Science, LSE Library.
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  4. Ana Fostel & John Geanakoplos, 2010. "Why does Bad News Increase Volatility and Decrease Leverage?," Working Papers 2010-18, The George Washington University, Institute for International Economic Policy.
  5. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  6. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
  7. 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.
  8. 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.
  9. Ana Fostel & John Geanakoplos, 2010. "Why Does Bad News Increase Volatility and Decrease Leverage?," IMF Working Papers 10/206, International Monetary Fund.
  10. Viral V. Acharya & S. Viswanathan, 2010. "Leverage, Moral Hazard and Liquidity," NBER Working Papers 15837, National Bureau of Economic Research, Inc.
  11. Gary Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," Yale School of Management Working Papers amz2358, Yale School of Management, revised 01 Sep 2009.
  12. 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.
  13. John Geanakoplos, 2010. "The Leverage Cycle," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 1-65 National Bureau of Economic Research, Inc.
  14. repec:cup:cbooks:9780521524131 is not listed on IDEAS
  15. 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.
  16. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.
  17. 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.
  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. 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.
  20. Markus K. Brunnermeier, 2008. "Deciphering the Liquidity and Credit Crunch 2007-08," NBER Working Papers 14612, National Bureau of Economic Research, Inc.
  21. repec:cup:cbooks:9780521524117 is not listed on IDEAS
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  23. Ana Fostel & John Geanakoplos, 2011. "Endogenous Leverage: VaR and Beyond," Cowles Foundation Discussion Papers 1800, Cowles Foundation for Research in Economics, Yale University.
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