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

62 Pages Posted: 4 Jun 2010

See all articles by Emine Boz

Emine Boz

International Monetary Fund (IMF)

Enrique G. Mendoza

University of Pennsylvania; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: May 2010

Abstract

Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors 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 overly optimistic about the persistence probability of a high-leverage regime. Conversely, the first realization of a low-leverage state turns agents unduly pessimistic about future credit prospects. These effects interact with the Fisherian deflation mechanism, resulting in changes in debt, leverage, and asset prices larger than predicted under either rational expectations without learning or with learning but without Fisherian deflation. The model predicts a large, sustained increase in net household debt and in residential land prices between 1997 and 2006, followed by a sharp collapse in 2007.

Suggested Citation

Boz, Emine and Mendoza, Enrique G., Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (May 2010). NBER Working Paper No. w16020. Available at SSRN: https://ssrn.com/abstract=1612614

Emine Boz (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Enrique G. Mendoza

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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