Dynamic Leveraging-Deleveraging Games

We introduce a new mechanism for leverage dynamics, which results from a multi-period game of lenders with differentiated beliefs about the firm's fundamental returns. The game features strategic substitutability for low existing leverage and one-sided strategic complementarity for high existing leverage. The resulting leverage process exhibits a mean-reverting regime around a long-run level, as long as it stays below an instability level. Above the instability level, leverage becomes explosive. We validate our model empirically using aggregate  returns of financial firms over the $10$ year period $2001-2010$. Our model predicts the leveraging/deleveraging of this period, and in particular the $2008$ collapse in short term debt.