TY  - JOUR
AU  - Boz,Emine
AU  - Mendoza,Enrique G.
TI  - Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 16020
PY  - 2010
Y2  - May 2010
UR  - http://www.nber.org/papers/w16020
L1  - http://www.nber.org/papers/w16020.pdf
N1  - Author contact info:
Emine Boz
International Monetary Fund
700 19th Street, N.W.
Washington, DC  20431
Tel: (240)423-6325
E-Mail: eboz@imf.org

Enrique G. Mendoza
Department of Economics
University of Pennsylvania
3718 Locust Walk
Philadelphia, PA 19104
Tel: 215-898-7701
E-Mail: egme@sas.upenn.edu
AB  - Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors 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 overly optimistic about the persistence probability of a high-leverage regime. Conversely, the first realization of a 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 predicts a large, sustained increase in net household debt and in residential land prices between 1997 and 2006, followed by a sharp collapse in 2007.
ER  -