Persistent Crises and Levered Asset Prices

We rationalize the joint behavior of aggregate consumption, asset prices, and financial leverage by incorporating persistent macroeconomic crises into a structural credit risk model. As in the data, longer-lasting crises are associated with more severe macroeconomic contractions and larger increases in leverage ratios, credit risk, and return volatility. Leverage provides a strong propagation mechanism for fundamental shocks because it continues to rise while crises endure. The model replicates the firm-level implied volatility curve and its cross-sectional relation with observable proxies of default risk. Lastly, a structural estimation reveals that common idiosyncratic risk is an important driver of credit spreads.