Belief Disagreements and Collateral Constraints

Belief disagreements have been suggested as a major contributing factor to the recent subprime mortgage crisis. This paper theoretically evaluates this hypothesis. I assume that optimists have limited wealth and take on leverage in order to take positions in line with their beliefs. To have a signi…cant e¤ect on asset prices, they need to borrow from traders with pessimistic beliefs using loans collateralized by the asset itself. Since pessimists do not value the collateral as much as optimists do, they are reluctant to lend, which provides an endogenous constraint on optimists’ability to borrow and to in‡uence asset prices. I demonstrate that the tightness of this constraint depends on the nature of belief disagreements. Optimism concerning the probability of downside states has no or little e¤ect on asset prices because these types of optimism are disciplined by this constraint. Instead, optimism concerning the relative probability of upside states could have signi…cant e¤ects on asset prices. This asymmetric disciplining e¤ect is robust to allowing for short selling because pessimists that borrow the asset face a similar endogenous constraint. These results emphasize that what investors disagree about matters for asset prices, to a greater extent than the level of disagreements. When richer contracts are available, relatively complex contracts that resemble some of the recent …nancial innovations in the mortgage market endogenously emerge to facilitate betting. JEL Codes: G1, G12, E3, D53 Keywords: Belief disagreements, heterogoeneous priors, collateral constraints, leverage, margin, asymmetric disciplining, short selling. Harvard University (e-mail: [email protected]). Earlier versions of this paper have been circulated under the title, “When Optimists Need Credit: Asymmetric Disciplining of Optimism and Implications for Asset Prices.” I am grateful to my advisor, Daron Acemoglu, for invaluable guidance and numerous suggestions that signi…cantly improved the paper. I thank Aytek Erdil, Sam Kruger, Muhamet Yildiz, three anonymous referees, and the editor, Stephen Morris, for numerous helpful comments. I also thank Marios Angeletos, Roland Benabou, Ricardo Caballero, Melissa Dell, Emmanuel Farhi, Guido Lorenzoni, Ivan Werning and the seminar participants at the University of California-Berkeley, Brown University, the University of Chicago, Chicago Fed, Columbia University, Duke University, the European University Institute, Harvard University, IMF, MIT, New York University, Northwestern University, the University of Pennsylvania, Princeton University, Stanford University, Toulouse University, the University of Warwick, Yale University for helpful comments. All remaining errors are mine.