The Allocation of Aggregate Risk, Secondary Market Trades and Financial Boom-Bust Cycles∗

The financial crisis of 2007-2008 started with the collapse of the market for Collateralized Debt Obligations backed by sub-prime mortgages. In this paper we present a mechanism aimed at explaining how a freeze in a secondary debt market can be amplified and propagated to the real economy, and thereby cause a recession. Moreover, we show why such a process is likely to be especially strong after a prolonged expansion based on the growth of consumer credit and endogenously low risk premia. Hence our model offers a new perspective on the links between the real and financial sectors, and we show how it can help make sense of several macroeconomic features of the 2001-2009 period. The key elements of the model are heterogeneity across agents in terms of risk tolerance, a financial sector that allocates systematic risk efficiently across agents, and real decisions that depend on the price of risk.