Innovation-mediated politics

August 20, 2009

There is one thing I get from Martha’s post. FICO scores are a key intellectual salvo in the “Berkeley controversy” between performativists and institutionalists. Do tools matter? Can devices be political? Martha’s account suggests a resounding yes.

Here’s why. Calculative tools, and specifically the FICO scores, are the key missing link between the interests of bankers and the interests of CDO investors in the credit crisis. In the Fligsteinian account of the crisis, Wall Street bankers induce the credit debacle by switching from selling prime mortgages to selling subprime mortgages… to preserve their profit margins. They certainly pursued their interests. But what the account seems to overlook is that any market transaction requires the agreement of two parties. Granted that bankers were offering crap. The question is – why were subprime investors buying it?

The institutional answer to this is isomorphism. It was junior portfolio managers who probably ended up buying up those subprime securities form greedy bankers. Why? Because their misguided bosses, aware that their rivals were racking up millions by going subprime, told them to do so… or else look for another job. Subprime investors are then the social fools that advanced Wall Street’s interests at the expense of their own.

I find this answer unsatisfactory. As with any diffusion story, it does not explain how the bandwagon got going: once every lemming is falling off the cliff, one can see herding at work. But why did heading for the cliff become a hot trend in the first place? My second misgiving to the “fools” explanation is that it assumes that subprime investors were not actively calculating the risk of their move. Presumably, those greedy bosses did not want to lose their jobs either. So how did they gauge the risks of their bet?

Martha’s work provides the answer. They did so with an instrument they had ready at hand – the FICO scores. And the FICO score was ready for them because it had already been developed to gauge something else entirely different: the risks of legitimate, investment grade prime mortgages.

The argument is so strong that it needs to be made clear: we would not have had a subprime crisis without FICO scores. Only the existence of a calculative tool can explain why one party – Wall Street – was able to advance their interests at the expense of another on a voluntary, free market exchange basis. As Martha writes, a case of “innovation mediated politics.” (For those who are not yet subscribed to the journal, here’s a link to the draft of the paper)

In advancing the empirical basis of this explanation, there are several points that can be pursued.

First, even if we grant that FICO scores allowed subprime investors to engage in a risk-return calculation, it is not a given that the answer would be “buy subprime.” Why was it? Here, Tett and MacKenzie’s account is critical: the problem was the incorrect correlation assumptions in the CDO matrices. So I would like to know more about the relationship between theirs and Martha’s account.

Second, if Martha’s mechanism is indeed at work, we should be able to find other historical parallels. That is, situations in which the forbidden trashy low end of an asset is brought into acceptability by the application of risk management tools used for the legitimate safer half. Are there examples of this? I’d like to suggest the development of junk bonds by Michael Milken in the late 1980s.

6 Responses to “Innovation-mediated politics”

  1. marthapoon Says:

    Thank you Daniel, for clarifying some of the institutionalist solutions, like isomorphism, to the problem of common action. This is helpful to understanding how this approach differs from SSF.

    It seems to me that institutionalists do not not see the problem of ‘valuation’ and its resolution (i.e. how agents evaluate, qualify, risk assess, price entities thereby rendering them objects of exchange) as being a key part of how market activities are generated.

    I wonder is there an equivalent if different concern at the heart of institutionalism, and if so, how it would be phrased, for the sake of comparison, if it were distilled out and expressed…?

  2. danielbeunza Says:

    That’s exactly right. Institutionalism is not about the content of valuation but about the context.

    And that’s what I thought that the tools approach to politics achieves: normally, political accounts do not include market transactions; power is the anti-matter to consensual agreements. A tools based approach offers a way to integrate politics in valuation, and thus show how interests clash or are reconciled in market transactions.

  3. marthapoon Says:

    So that being said, an account of tools is not devoid of political actors (in the traditional sense), nor is it devoid of the kinds of actors institutionalist are interest in such as firms / organizations / corporations.

    I’m always a little taken aback when people say SSF is ‘just’ about technology, as though the focus is too narrow. Yet, as so many studies of shown the establishment of technologies involves the coordination of a wide range of interest groups / stakeholders.

    In the case we’ve been discussing, for example, for subprime lending to emerge FICO must come to be adopted over other methods by a wide variety of actors, who do not have much direct contact: the GSEs, mortgage brokers, loan wholesalers, ratings agencies, investment banks, investors, and so on.

    It is the politicking that goes on around the establishment of (universal) technologies that SSF brings to light and argues should not be taken for granted.

  4. Alex Says:

    the institutionalist perspective doesn’t appear to contradict the performativist focus on “tools”. Actually they seem to be complementary. One question might be how the “politics” of such tools were institutionalised and became norms at a specific point/period in time. To answer this question, maybe one needs to zoom out one more level and look at the fields in which institutional struggles occur.

  5. zsuzsannavargha Says:

    “any market transaction requires the agreement of two parties. Granted that bankers were offering crap. The question is – why were subprime investors buying it?”

    Thanks for the nice post, Daniel. I want to add two things to this particular issue, in increasing order of strength and increasing use of Liar’s Poker…

    First, mortgage bonds a la Salomon Brothers as well as junk bonds a la Milken had to have buyers, they didn’t sell themselves by virtue of people being greedy or companies needing profit. Somehow these new products had to be explained as making sense for specific investors, why they are good for each other. Either by reference to the investor’s specific portfolio, or to a trend (if you look out the window you can see that fashionable people are wearing …junk bond), or to a risk management model. Milken seems to have spent most of his energy on going out to potential investors and presenting them the novelty lucrative product, the junk bond. But mortgage bonds were apparently also pitched to Savings and Loan presidents. In short, I agree with Daniel that all the actors have their agenda but that doesn’t account for why products start to flow.

    “bringing into acceptability”…
    So for junk bonds and CDOs, I think the Madoff type of question arises: what does it mean to perform a legitimate asset? This involves face-to-face performances just as much as it does risk management tools (Daniel pointed to the latter, a very exciting idea). However, as some of us argued in relation to Ponzi that starting our analysis from the standpoint that the products were crap (the scheme was fraudulent) misses the part where actors are acting, calculating their own and others’ interests.

    I think the lemming metaphor is useful because it is inaccurate on so many counts: for example, “heading for the cliff” presumes that we outside observers can see a cliff, and as Daniel pointed out we judge the lemmings in hindsight as either helpless or greedy fools. (In this spirit, what does it mean to say that the calculations were incorrect?)

    Second, I want to question the stability (of diffusion) argument as well. I.e. when the lemmings are already heading to the cliff and are already falling one after the other. Really, it’s that smooth?

    When Michael Lewis accounts for his job as “salesman” at Salomon, he demonstrates that connecting and adjusting buyers and sellers is an ongoing effort, that requires convincing each and anew that they should be parties to an exchange. This kind of work seems to pertain not only to new products but “plain vanilla” ones as well. So, what looks like herding is actually the work of Michael Lewis-type of salesmen who make money move by qualifying it–explaining how a specific volume and quality of product fits exactly with that client’s plans. This adjusting and connecting is what I try to show in the case of everyday consumer banking, as the process by which transactions emerge and it is very technical. It would be a mistake to call what is going on “manipulation,” or to see it as somehow not economic, e.g. a purely social struggle of opposing interests. It is part and parcel of making transactions happen. Is it political? Of course.

  6. danielbeunza Says:

    Agreed! There is a lot of “behind the scenes” work to get the bandwagon rolling. What is amazing is that this work is not really hidden or secret. It’s only ignored by academics because it does not fit existing theoretical positions.

    Would be fascinating SSF project to study these roadshows as performances. How PowerPoint turns a strange and scary financial innovation into an acceptable and desirable.


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