Credit Cycles, Securitization, and Credit Default Swaps

TL;DR

This paper develops a limits-to-arbitrage model to analyze how securitization, leverage, and credit risk protection influence banking credit cycles, highlighting mechanisms that lead to credit booms and busts and their impact on the real economy.

Contribution

It introduces a novel limits-to-arbitrage model linking securitization, leverage, and credit risk to banking credit cyclicality, emphasizing the effects of mis-pricing and trading in credit derivatives.

Findings

Unlevered securitization increases credit cycle volatility.

Leverage amplifies banking profits and causes banks to sell securities during downturns.

Mis-pricing of credit risk reduces funding for high-risk borrowers and liquidity of securitized assets.

Abstract

We present a limits-to-arbitrage model to study the impact of securitization, leverage and credit risk protection on the cyclicity of bank credit. In a stable bank credit situation, no cycles of credit expansion or contraction appear. Unlevered securitization together with mis-pricing of securitized assets increases lending cyclicality, favoring credit booms and busts. Leverage changes the state of affairs with respect to the simple securitization. First, the volume of real activity and banking profits increases. Second, banks sell securities when markets decline. This selling puts further pressure on falling prices. The mis-pricing of credit risk protection or securitized assets influences the real economy. Trading in these contracts reduces the amount of funding available to entrepreneurs, particularly to high-credit-risk borrowers. This trading decreases the liquidity of the securitized assets, and especially those based on investments with high credit risk.