Habits and Leverage (with Tano Santos)

Abstract:
Many stylized facts about leverage, trading, and asset prices can be explained by a frictionless general equilibrium model with countercyclical uncertainty and heterogeneous agents with external habit preferences. Our model predicts that aggregate leverage increases in good times, it should predict low future returns and should be correlated with a “consumption boom” of levered agents. In addition, negative aggregate shocks induce leveraged agents to deleverage by “fire-selling” their risky positions as their wealth drops. While such agents’ total leverage decreases, their debt/wealth level increases as wealth value is especially sensitive to changes in aggregate risk aversion.