Collateralization and asset price bubbles when investors disagree about risk

Abstract

Abstract Survey respondents disagree strongly about the dispersion of future returns and, increasingly, macroeconomic uncertainty. Such disagreement about risk may raise asset prices when collateralized debt products allow investors to realize perceived gains from trade. Investors who expect low volatility in collateral cash-flow appreciate senior debt as riskless. Those who expect high volatility, in contrast, value the upside potential in junior debt or equity claims. We show how such self-selection may have had a sizeable effect on the prices of RMBS and CDOs before the crisis, as investors disagreed about the volatility of aggregate economic conditions and their importance for default rates in collateral pools.