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

63 Pages Posted: 19 Jul 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: 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.

Suggested Citation

Boz, Emine and Mendoza, Enrique G., Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (July 2010). IMF Working Papers, Vol. , pp. 1-62, 2010. Available at SSRN: https://ssrn.com/abstract=1641015

Emine Boz

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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