We consider a moral hazard setup wherein leveraged firms have incentivesto take on excessive risks and are thus rationed when they attempt toroll over debt. Firms can sell assets to alleviate rationing. Liquidatedassets are purchased by non-rationed firms but their borrowing capacityis also limited by the risk-taking moral hazard. The market-clearingprice exhibits cash-in-the-market pricing and depends on the entiredistribution of leverage (debt to be rolled over) in the economy. Thisdistribution of leverage, and its form as roll-over debt, are derived asendogenous outcomes with eachfirm's choice of leverage affecting thedifficulty of otherfirms in rolling over debt in future. The modelprovides an agency-theoretic linkage between market liquidity andfunding liquidity and formalizes the de-leveraging offinancialinstitutions observed during crises. It also explains the role played bysystem-wide leverage in generating deep discounts in prices when adverseasset-quality shocks materialize in good times.
