Credit-fuelled bubbles

Abstract

We develop a model of credit-fuelled bubbles in which lenders accept risky assets as collateral. Asset prices and credit reinforce each other, as booming asset prices allow lenders to extend more credit, enabling investors to bid prices even higher. If investors are asymmetrically informed, there exist equilibria in which it is optimal to ride bubbles, buying overvalued assets in hopes of reselling at a profit to a greater fool. Lucky investors sell the bubbly asset at peak prices, only to buy it again at or below fundamental value after the crash. Unlucky investors, who buy at the peak hoping that the bubble continues to grow at least a bit longer, suffer losses. If the degree of leverage is sufficiently high, lenders repossess and liquidate the assets of unlucky investors, and may continue to seize their endowments until debts are fully repaid. In our model, raising interest rates and regulating maximal loan-to-value and loan-to-income ratios can reduce or even eliminate bubbles.