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

Author/Editor: Mendoza, Enrique ; Boz, Emine
Publication Date: July 01, 2010
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate
Summary: 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.
Series: Working Paper No. 10/164
Subject(s): Credit expansion | United States | Financial instruments | Household credit | Housing prices | Asset prices | Credit risk | Financial crisis | Economic models

Publication Date: July 01, 2010
ISBN/ISSN: 9781455201754 Format: Paper
Stock No: WPIEA2010164 Pages: 59
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