COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1809R Tranching, CDS and Asset Prices: Ana Fostel and John Geanakoplos July 2011 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. |
