Goldman, the SEC and performativity
April 26, 2010
There has been no shortage of blog commentary on the recent civil suit by the SEC against Goldman Sachs. In my view, the case also makes clear the value of Donald MacKenzie’s view of the credit crisis, and the notion of performativity. In a recent and ambitious article, MacKenzie has argued that the credit crisis was caused by the counter-performativity of the models employed to rate mortgage derivatives. The Goldman episode provides clear proof of the value of these ideas, and the need for sociologists to engage with them.
Let us first review the case. In essence, the SEC’s claim is that Goldman stuffed its mortgage derivatives with bad mortgage bonds. It did so to please an esteemed client who wanted to bet against the housing bubble, John Paulson. And having done so, it concealed it from its other clients – the ones who were betting that the securities were sound. These clients, the unlucky European banks IKB and ABN Amro, bought the securities, lost millions and subsequently went bankrupt.
A mystery remains
For all the light on the ugly side of human nature that the case seemingly sheds, one critical mystery remains. Why did the Europeans buy these derivatives? Implicitly, the financial press has presented these bankers as naïve or, in the extreme, irrational. In my view, however, the answer is a different one and has to do with performativity.
The concept of performativity speaks to the relationship between economics and the economy: economists create models that investors use, shaping prices in ways that make the models more accurate. The opposite process is also possible. A model is counter-performative when its use makes the model less accurate. MacKenzie (2009) argues that the reverse dynamic is what happened in the credit crisis. The models used by investors to value mortgage derivatives made these models a less accurate representation of value. In fact, MacKenzie does not just refer to models, but also to indexes, cultural norms and organizational arrangements.
MacKenzie (2009) focuses on the use of the rating system to value credit derivatives such as collateralized debt obligations. The use by the credit rating agencies of a fixed set of characteristics, clearly specified and communicated to investors through software packages such as S&P’s Evaluator, made it possible for investors to game the system. It worked as follows: every security has multiple qualities and characteristics. Knowing that only a few of them are quantified and used to value the credit derivatives, the arrangers of these derivatives took bonds of mortgages that were on the whole close to worthless but that looked good from the narrow standpoint of the credit rating. Investors could naturally choose to evaluate these mortgage derivatives themselves. But given their sheer complexity, the speed at which they had to respond to bid-lists (a few hours), and the fact that credit rating had worked perfectly well in the past, few of them chose to do this.
Why buy a toxic asset?
This, in short, is why IKB and ABN Amro bought mortgage derivatives. The very mortgage derivative that led to the problem, ABACUS, was rated as a safe security. These companies were credible, at the time. Past precedence was reassuring. They went ahead.
Interestingly, this is also why John Paulson shorted those same mortgage derivatives. He knew the game that some issuers were playing. He reputedly asked Goldman to put together a security with bonds that excluded the most honest actors. The goal was to explicitly create something that looked fine under the rating system, but that in fact was worthless. And then, bet against it.
One security, two valuation systems — both of them seemingly legitimate. And two opposite views about the same security: the European banks in favor, Paulson against. The crucial detail that might perhaps have given the game up to the Europeans – that John Paulson was taking the opposite side — was apparently concealed by Goldman.
What do we learn? It is unclear, at this point, whether the SEC will be able prove its case in court, or how will Goldman’s reputation survive the case. But what is certain is that the European banks were not irrational or naïve. They were unaware of a complex process of counter-performativity that would continue to march on… to the point of bankrupting Lehman, Bear, RBS and a long list of others. The Goldman episode and the credit crisis illustrate the effectiveness of MacKenzie’s analysis, of performativity, and the intellectual potential of the social studies of finance.