Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
63 Pages Posted: 19 Jul 2010
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Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
Date Written: July 2010
Abstract
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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