Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes
CFDP Revision Date
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.
Fostel, Ana and Geanakoplos, John, "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes" (2011). Cowles Foundation Discussion Papers. 2155.