CFDP 1809R

Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes

Author(s): 

Publication Date: July 2011

Revision Date: August 2011

Pages: 48

Abstract: 

We show how the timing of financial innovation might have contributed to the mortgage bubble and then to the crash of 2007-2009. We show why tranching and leverage first raised asset prices and why CDS lowered them afterwards. This may seem puzzling, since it implies that creating a derivative tranche in the securitization whose payoffs are identical to the CDS will raise the underlying asset price while the CDS outside the securitization lowers it. The resolution of the puzzle is that the CDS lowers the value of the underlying asset since it is equivalent to tranching cash.

Keywords: 

Financial innovation, Endogenous leverage, Collateral equilibrium, CDS, Tranching and asset prices

JEL Classification Codes:  D52, D53, E44, G01, G10, G12

See CFP: 1353