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

  • Enrique G. Mendoza
  • Emine Boz

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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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
Handle: RePEc:imf:imfwpa:10/164
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