Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes
- (pp. 190-225)
Abstract
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).Citation
Fostel, Ana, and John Geanakoplos. 2012. "Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes." American Economic Journal: Macroeconomics, 4 (1): 190-225. DOI: 10.1257/mac.4.1.190Additional Materials
JEL Classification
- E32 Business Fluctuations; Cycles
- E44 Financial Markets and the Macroeconomy
- G01 Financial Crises
- G12 Asset Pricing; Trading volume; Bond Interest Rates
- G13 Contingent Pricing; Futures Pricing; option pricing
- G21 Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
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