Default Contagion in a Two-Tree Economy

Abstract

We propose an explanation for default contagion based on a Lucas model with two independent debt-financed trees. The transmission mechanism is that variations in the size of one tree impact the level of risk premium and the default decision for all borrowers. If a negative shock hits one tree, the other tree contributes to a larger proportion of aggregate consumption and thus bears more systematic risk. The resulting higher risk premium increases the cost of debt and tilts that borrower's decision towards default. This mechanism induces contagion in default probabilities, leverage, and financial volatility across borrowers with uncorrelated fundamentals. The effect is stronger for borrowers with greater rollover needs.