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

57 Pages Posted: 24 Aug 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: August 2010

Abstract

Uncertainty about the riskiness of a new financial environment 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 the new environment. Early realizations of states with high ability to leverage assets into debt turn agents overly optimistic about the probability of persistence of a high-leverage regime. Conversely, the first realization of the 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 can account for 69 percent of the rise in net household debt and 53 percent of the rise in residential land prices between 1997 and 2006, and it predicts a sharp collapse in 2007.

Keywords: asset prices, credit crisis, financial innovation, Fisherian deflation, imperfect information, learning

JEL Classification: D82, E44, F41

Suggested Citation

Boz, Emine and Mendoza, Enrique G., Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis (August 2010). CEPR Discussion Paper No. DP7967. Available at SSRN: https://ssrn.com/abstract=1661570

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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