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

Abstract:     
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.

Number of Pages in PDF File: 48

Keywords: Financial innovation, Endogenous leverage, Collateral equilibrium, CDS, Tranching and Asset prices

JEL Classification: D52, D53, E44, G01, G10, G12

working papers series