Belief Heterogeneity, Collateral and Endogenous Leverage

Abstract

This paper proposes a novel approach in a general equilibrium model to assess how belief heterogeneity affects equilibrium and contract origination. The market offers a menu of collateralized debt contracts depending on leverage and interest rates. Borrowers select a single contract from the menu, whereas lenders take the choice as given. Binding collateral constraints raise asset prices above their fundamental value. The model establishes that changes in market average beliefs rather than belief disagreement determine asset prices and leverage comovement. Under mild technical conditions, asset prices and leverage move in opposite directions. Extensions of the model show the interaction of endogenous leverage and credit extension in the mortgage market, and the Minsky moment obtains in equilibrium. Finally, macroprudential regulatory policy is evaluated.