(Tip of the hat for pointing out Mackenzie’s article to Dan Hirschman)
The financial crisis, it is quite clear by now, will be the worst worldwide economic catastrophe since the Great Depression. There are many explanations involving mistaken or misused economic theory, rapaciousness, political decisions, ignorance, and many more; two interesting examples here are Alp Simsek’s job market paper from a couple years ago on the impact of overly optimistic potential buyers who need to get loans from sedate lenders (one takeaway for me was that financial problems can’t be driven by the ignorant masses, as they have no money), and Coven, Jurek and Stafford’s brilliant 2009 AER on catastrophe bonds (summary here) which points out how ridiculous it is to legally define risk in terms of default risk, since we have known for decades in theory that Arrow-Debreu securities’ values depend both on the payoffs in future states and on the relative prices in those states. A bond whose default occurs in catastrophic states ought be much more expensive than the same bond whose default is negatively correlated with background risk.
But the catastrophe also involves a sociological component. Markets are made: they don’t arise from thin air. Certain markets don’t exist for reasons of repulsion, as Al Roth has mentioned in the context of organ sales. Other markets don’t exist because the value of the proposed good in that market is not clear. Removing uncertainty and clarifying the nature of a good is a important precondition, and one that economic sociologists, including Donald Mackenzie, have discussed at great length in their work. The evaluation of new products, perhaps not surprisingly, depends both on analogies to forms a firm has seen before, and on the particular parts of the firm who handle the evaluation.
Consider the ABS CDO – a collateralized debt obligation where the underlying debt are securitized assets, most commonly mortgages. The ABS CDO market grew enormously in the 2000s, and was not understood at nearly the same level as traditional CDO or ABS evaluation, topics on which there are hundreds of research papers. ABS and CDO teams tended to be quite separate in investment banks and ratings agencies, with the CDO team generally well trained in derivatives and the highly quantitative evaluation procedures of such products. For ABSs, particularly US mortgages, the implicit government guarantee against default meant that prepayment risk was the most important factor when pricing such securities. CDOs, often based on corporate debt, were used to treating correlation between various corporations in a given CDO as the most important metric.
Mackenzie gives exhaustive individual detail, but roughly, he does not blame the massive default rates on even AAA-rated ABS CDOs on greed or malfeasance. Rather, he describes how evaluation of ABS CDOs by ratings agencies used to dealing with either an ABS or a CDO, but not both, could lead to a utter misunderstanding of risk. While it is perfectly possible to “drill down” a complex derivative into its constituent parts, then subject the individual derivative to a stress test against some macroeconomic hypothetical, this was rarely done, particularly by individual investors. Mackenzie also gives a brief story of why these assets, revealed in 2008 to be superbly high risk, were being held by the banks at all instead of sold off to hedge funds and pensions. Apparently, the assets held were generally ones with very low return and very low perceived risk which were created as a byproduct of the bundling that created the ABS CDOs. That is, arbitrage was created when individual ABSs were bundled into an ABS CDO, the mezzanine and other tranches aside from the most senior AAA tranche were sold off, and the “basically risk-free” senior tranches were held by the bank as they would be difficult to sell directly. The evaluation of the risk, of course, was mistaken.
This is a very interesting descriptive presentation of what happened in 07 and 08.
http://www.socialwork.ed.ac.uk/__data/assets/pdf_file/0019/36082/CrisisRevised.pdf (Final version from the May 2011 American Journal of Sociology)
A Fine Theorem 