Ambiguity Shifts and the 2007-2008 Financial Crisis

Abstract

I analyze the effects of model misspecification on default swap spreads and equity prices for firms that are not perfectly transparent to the investors. The agents in the economy are misspecification-averse and thus assign higher probabilities to lower utility states. This leads to higher CDS rates, lower equity prices and lower expected times to default. Estimating the model using data on financial institutions, I find that the sudden increase in credit spreads in the summer of 2007 can be partially explained by agents' mistrust of the signals observed in the market. The bailout of Bear Stearns in March 2008 and the liquidation of Lehman Brothers in September 2008 further exacerbated the agents' doubts about signals quality and introduced mistrust about the agents' pricing models, accounting for the further increases in credit spreads after these events.