Asset Pledgeability and Endogenously Leveraged Bubbles

Abstract

We develop a simple model of defaultable debt and rational bubbles in the price of an asset, which can be pledged as collateral in a competitive credit pool. When the asset pledgeability is low, the down payment is high, and bubble investment is unleveraged, as in a standard rational bubble model. When the pledgeability is high, the down payment is low, making it easier for leveraged borrowers to invest in the bubbly asset. Moreover, when loans are pooled together in a competitive market, the pricing of individual default risk may facilitate risk-taking. In equilibrium, credit-constrained borrowers may optimally choose a risky leveraged investment strategy -- borrow to invest in the bubbly asset and default if the bubble bursts. The model implies a close relationship between the boom and bust of housing prices and securitized credit.

Keywords: rational bubbles, collateral, household debt, equilibrium default

JEL Classification: E12; E24; E44; G01