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

Author/Editor:

Enrique G. Mendoza ; Emine Boz

Publication Date:

July 1, 2010

Electronic Access:

Free Download. Use the free Adobe Acrobat Reader to view this PDF file

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. 2010/164

Subject:

English

Publication Date:

July 1, 2010

ISBN/ISSN:

9781455201754/1018-5941

Stock No:

WPIEA2010164

Pages:

62

Please address any questions about this title to publications@imf.org