News, Credit Spreads and Default Costs: An expectations-driven interpretation of the recent boom-bust cycle in the U.S

The years leading up to the "great recession" were a time of rapid innovation in the financial industry. This period also saw a fall in credit spreads and a boom in liquidity and asset prices that accompanied the boom in real activity, especially investment. In this paper we argue that these were not unrelated phenomena. The adoption of new financial products and practices led to a fall in the expected costs of default which in turn engendered the flood of liquidity in the financial sector, lowered interest rate spreads and facilitated the boom in asset prices and economic activity. When the events of 2007-2009 led to a re-evaluation of the effectiveness of these new products, agents revised their expectations regarding the actual efficiency gains available to the financial sector and this led to a withdrawal of liquidity from the financial system, a reversal in credit spreads and asset prices and a bust in real activity. We treat the efficiency of the financial sector as an exogenous process governing bankruptcy (monitoring) costs facing intermediaries in a costly state verification framework and study the impact of "news shocks" regarding this process. Following the expectations driven business cycle literature, we model the boom and bust cycle in terms of an expected future fall in bankruptcy costs which are eventually not realized. The build up in liquidity and economic activity in expectation of these efficiency gains is then abruptly reversed when agent's hopes are dashed. The model generates counter-cyclical movements in the spread between lending rates and the risk-free rate which are driven purely by expectations, even in the absence of any exogenous movement in intermediation costs as well as an endogenous rise and fall in asset prices and leverage.