Credit Cycles, Securitization, and Credit Default Swaps

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.