Financial innovation, the discovery of risk, and the U.S. credit crisis

Financial innovation and overconfidence about the risk of new financial products were key factors behind the 2008 U.S. credit crisis. We show that a model with a collateral constraint in which learning about the risk of a new financial environment interacts with Fisherian amplification produces a boom–bust cycle in debt, asset prices and consumption. Early realizations of a high-borrowing-ability regime turn agents optimistic about the persistence probability of this regime. Conversely, the first realization of a low-borrowing-ability regime turns agents unduly pessimistic. The model predicts large increases in household debt, land prices and excess returns during 1998–2006 followed by a collapse. •Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors behind the U.S. credit crisis.•Recent crisis was preceded by two key facts: First, increases in household credit, residential land prices, and leverage ratios.•Second, financial innovation of a scope and magnitude unseen since the aftermath of the Great Depression.•We propose a model where collateral constraints and learning about riskiness of a new financial regime interact to produce amplification.•The model predicts big surges in household debt, land prices and excess returns during 1998-2006 followed by a collapse.