Abstract
Starting around 1990, financial intermediaries in the United States increasingly began to sell, rather than hold to maturity, many of the loans that they provided to households and firms. This paper presents a theory in which the endogenous growth of such secondary market trading generates a macroeconomic credit cycle. Growing secondary markets initially boost credit volumes but gradually lead credit to flow to excessively risky investments. Aggregate risk exposure builds as asset quality falls. Ultimately, a negative shock leads to a simultaneous collapse of secondary markets and credit volumes ‐ as in the financial crisis of 2008. Booms are triggered by periods of low interest rates, and longer booms lead to sharper crises. Saving gluts and expansionary monetary policy thus lead to financial fragility over time. Pro-cyclical regulation of secondary market traders, such as asset managers or hedge funds, can improve welfare even when such traders are not levered.
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