Debt Collateralization, Capital Structure, and Maximal Leverage

Many capital structures implicitly or explicitly give agents the ability to use debt contracts as collateral for other financial promises. We study the effects of allowing debt to be used as collateral in a general equilibrium model with heterogeneous agents, collateralized financial contracts, and multiple states of uncertainty. When agents cannot use debt contracts as collateral, some agents borrow using risky debt and others borrow with risk-free debt. With debt collateralization, agents switch to high-leverage contracts, margin requirements decrease, and risk premia decrease. We provide testable implications regarding how funding markets affect capital structure, economy-wide margins, and price volatility