Reactions to Tett/MacKenzie: Anush Kapadia and the “liquidity crisis hypothesis”
June 16, 2009
Anush Kapadia just posted a fascinating reaction to Donald MacKenzie’s review of Gillian Tett’s book on the credit crisis. I thought that the elaborate comment, buried under eleven previous comments, deserved a lot more prominence. Here it is:
Tett’s is the best account I have seen of the crisis, but she leaves us asking the question: why did super-senior tranches of CDOs and synthetics prove to be the achilles heel of the system? She gives us a few clues, and MacKenzie picks up on one of them, correlation, in his review. While adequately measuring correlation was of course critical, hiking the level of correlation would still fail to account for the magnitude of the disaster. Leaving dollars on the sidewalk, both MacKenzie and Tett provide the materials for a more satisfying answer without putting these ingredients together. Perry Mehrling, ironically cited as an historian of economics by MacKenzie rather than the historically-informed monetary economist he is, has.
The key ingredient for a fuller story is an account of liquidity; it is here that MacKenzie always seems to fall short, (Mehrling has a liquidity-driven account of LTCM as well). The term is of course notoriously difficult to define uniquely, but its frequent pairing with the word “deep” ought to tell us something. Liquidity suggests robustness: a market is liquid if one can buy and sell in significant amounts without affecting the price. But who does one deal with? Typically, a market maker offering a spread. It is thus the ecology of market makers that ultimately determines the depth and resilience of a given market, offering to deal in any amount at their stated prices. The robustness of a market thereby reduces to the robustness of the balance sheets of the key market makers therein. The facticity of the “public fact” of market price thus rests on the ability of market markers to fund themselves. Once these balance sheets start to look anaemic, the prices built on them start to look less reliable.
So it was with the key “public fact” that both Tett and MacKenzie point to: the CDS indices. Oddly, MacKenzie does not think it fit to bring up the key role of the indices that he himself eloquently pointed to in his “End-of-the-World Trade” in his review of Tett. This is unfortunate as Tett is quite categorical about their centrality, and indeed her interpretation differs significantly from MacKenzie’s. For Tett, as for Mehrling, the important thing about the indices was that, being more standardised, their market was more liquid and therefore their prices more reliable. Robust pricing in the liquid derivative ABX index would then enable traders to price the illiquid underlying CDO tranches. Tett:
“Trading in mortgage bonds, let alone mortgage derivatives, was sparse. The only obvious guide was the ABX index, which had been launched in 2006. It provided a gauge of the value of the range of bonds in the CDOs—from BBB to AAA. So what many funds—including Bear Stearns—did was to look at the prices as given by ABS and then use that to deduce the prices of the bonds in their own CDOs,” (pg. 171).
MacKenzie notes this relationship in EOTWT, but for him it is not a matter of trading providing liquidity to a price point but trading providing solidity to the facticity of correlation:
“…trading of index tranches made correlation into something apparently observable and even tradeable. The Gaussian copula or similar model can be applied ‘backwards’ to work out the level of correlation implied by the cost of protection on a tranche, which again is publicly known.”
Correlation is critical to MacKenzie’s story because it goes into the manufacturing of that archetypical public fact, ratings. This is true in both EOTWT and the Tett review. In the latter, he notes that “Essential to the [CDO] assembly line was that the higher tranches of its final products…be able to gain Aaa ratings. A critical issue was the likely correlation of mortgage-backed securities.” This focus on correlation over and above the trading architecture leads MacKenzie to interpret Tett too narrowly, in my view, and thereby to miss a critical functional feature of a public fact that he has himself sniffed out as vital. Of course, Tett leaves herself open to this interpretation because she does not fully spell out the criticality of the CDS indices and their consequent impact on the super-senior tranche prices.
MacKenzie suggests that Tett is praising the Morgan credit derivative inventors for noting an empirical fact, that mortgage default correlations were simply unobservable and therefore the risk in betting on them could not be prudently measured. In the absence of further explication, Tett does indeed give this impression, and MacKenzie’s own commitment to correlation pushes him further in this direction, (although it is indeed strange that, in light of his own observation that CDS indices gave these correlations public facitcity, he does not think the indices warrant a mention in his Tett review). But Tett’s observation that is it trading and therefore liquidity in the CDS indices that enabled the pricing of the underlying CDOs leads us in another direction: not to facticity from modelling and ratings but facticity from trading.
To be fair, MacKenzie does note the importance of trading, but it appears to him merely as a “fact-generating mechanism” by way of marking-to-market. Thus he notes towards the end of EOTWT that:
“It has become common to use a set of credit indices, the ABX-HE (Asset Backed, Home Equity), as a proxy for the underlying mortgage market, which is now too illiquid for prices in it to be credible. However, the ABX-HE is itself affected by the processes that have undermined the robustness of the apparent facts produced by other sectors of the index market; in particular, the large demand for protection and reduced supply of it may mean the indices have often painted too uniformly dire a picture of the prospects for mortgage-backed As Carruthers and Stinchcombe note, market liquidity depends on facts. However, today’s financial facts depend on liquidity. The credit markets remain stuck in a vicious circle.”
But if liquidity is so critical why, despite Tett’s corroborating suggestion, does MacKenzie provide no account of it as generative of facticity in addition to the other way round? Tett herself elides the matter.
Liquidity is the missing piece of the puzzle that enables us to understand Tett’s main point regarding the impairment of the super-senior tranches of CDOs. Simply put, these “safer than safe” tranches were so badly hit not merely because all of Wall St. neglected the extent of the correlation of the underlying mortgages but because the markets that priced these tranches had no market maker of last resort. No emergency market-maker, no liquidity, no rational pricing.
When the banks need liquidity, they go to the interbank market and borrow/lend at LIBOR. When they all run out, they go to the central bank’s discount window. As Tett points out, shadow banks had only one liquidity backstop: the absolutely vital “liquidity puts” with the banks themselves, (MacKenzie makes no mention of them at all. See Tett pg. 205-6). Insurance sellers on the ABX were also providing a kind of backstop, and those backing up AAA risks were in effect backing up systemic risk, really the only kind of risk that is expressed in that coveted rating. By making AAA insurance contracts liquid, insurance market makers were implicitly acting as systemic risk providers. Cheap liquidity led them to underprice systemic risk and help create an unsustainable credit boom. When this became clear and everyone ran for the doors, there was no market maker of last resort who the system as a whole could turn to. The system itself melted because the systemic watchdogs were private, profit-driven entities (AIG and the monolines) who, when it comes to systemic risk, are by definition under-capitalized. With the backstops blown out, even the safer-than-safe risks looked unsafe.
This answers the question MacKenzie poses at the end of EOTWT: “Why…have people not been selling end-of-the world insurance when the returns from doing so have jumped ten-fold while the risk of having to pay out remains small?” As noted above, he cites mark-to-market as the paradoxical answer: that fact-generator now blocks the reestablishment of the pubic fact because of…lack of liquidity! This is not paradoxical but circular: what is the difference between mark-to-market as fact generator and fact inhibitor? More generally, when do positive feedback loops turn into negative ones, and why?
A more coherent answer, unavailable in MacKenzie’s vocabulary, is that, in the absence of a liquidity backstop to the insurance market, traders did (do?) not have a sense that the outcomes are bounded in any way. When we are talking about system risk insurance, the only entity capable of providing this backstop is the state (given its super-sized balance sheet) as it does through its central bank in the interbank market, and even it might prove insufficient. We were missing such an entity in the key CDS index markets, markets that form a structural analogy in the erstwhile shadow banking system to the boring credit markets of its “regulated” parent. Given that such devices are only ever the creation of crises, we ought not to be surprised at their absence. But if we want to get these markets starting again, we ought to be agitating for their construction. This is precisely what Mehrling has been doing.
That MacKenzie came so close to this answer but failed to connect the dots might indicate that SSF has a serious epistemological blind spot. So I would like to end this over-long post by briefly reflecting on what this absence of attention to market structure and credit means for the sociology of finance. MacKenzie has made his name by seeking to break open the black boxes of finance and eschew the Parsonian division of labour between sociology and economics. While he has gone further than anyone else in doing this, he has not gone far enough. This is perhaps understandable given his role as a pioneer, but those who have followed in his wake tend to replicate the error, academic markets being acutely prone to herding. While consistently being drawn to the most interesting and critical aspects of modern finance, MacKenzie’s tight focus on particular models and markets has left us without a more general theory of market activity and the pivotal role of the credit markets generally, even when discussing the crisis.
This is ironic, for market making, liquidity, and ultimately credit-money itself are perhaps the most performative aspects of our modern economy. Yet because their performativity has macro-structural predicates—ultimately undergirded by a market theory of money—these objects fall outside the purview of SSF. Yet this is precisely where economic sociology might really take on a faltering mainstream economic paradigm. It is not simply that economics is performative. The critical question is, if the economy is a social entity that does not submit to the scientism of modelling, how is macroeconomic control achieved at all, and how does it break down?
In the conclusion to EOTWT, MacKenzie points out that the power of central banking comes ultimately from the state’s power to tax. True, but this power remains platonic as a control device unless there is a social mechanism for its transmission. Since the inception of central banking, this mechanism has been the credit markets. What does it say about SSF that it was silent on these “boring” markets till after this crisis?
(For Perry Mehrling’s account of the crisis, from which this post is drawn, refer to his interventions here: