The NY Times has an interesting op-ed about behavioural approaches to financial markets; specifically mentioning the crucial importance of conceptual frames in decision making. All the usual suspects are there: Tversky & Kahneman, Thaler, Shiller, Ariely and, of course, Taleb. Still, it’s nice to see that behavioural finance is making inroads into the mainstream media. What’s next: economic sociology and institutional approaches to markets on WJS? Well, stranger things have happened…

Prem Sikka, who is a well-known critic of the current accounting system, is providing yet another list of companies who are now failing financial, but receiving a ‘clean bill of health’ from the auditors regarding their latest annual reports. We cannot argue with the facts, of course, but when it comes to explaining the reasons, or perhaps the mechanisms behind the auditing failures, we may have to dig deeper. Sikka is saying that

auditors are expected to be independent of the companies that they audit [yet] Auditors continue to act as advisers to the companies that they audit. They are hired and remunerated by the very organisations that they are supposed to be auditing. The auditor’s dependence for fees on corporate barons makes it impossible for them to be independent.

The dynamic implied in this described structural set of affairs is that there is self-censorship on the account of the auditor. Auditors realize that things are wrong with the companies they audit, yet – fearing for their auditing and consulting fees – they let things slip, hoping that there won’t be a complete collapse. I guess that the main concern I have here is empirical. The picture described sounds plausible, especially if remember the cases of Enron and WorldCom, but to establish the theory we would need to examine cases of auditors who did try to ‘test their clients’. That is, what would happen to an auditing firm that would not give a ‘clean bill of health’ to a large client? Would they lose lucrative consulting contracts with that client? Maybe even have their auditing contract withdrawn? If it can be shown empirically that such organisational set of norms on the part of the auditors’ clients exists and brings about effective results (i.e. auditors yield to their clients’ wills) then the theory of the auditor’s structural dependence on the client can be strengthened.   

Furthermore, in boiling down the role of the auditor to an agent that simply has to make the decision of either being independent (and then, possibly, pay the prices), or play along with the client, we portray a picture of reality that is too simplistic. For example, it can be assumed that there are different mechanisms in which a client and an auditor interact and surely not all of them bring about the same result of independence or, as Sikka suggests, the lack thereof.


The British Bankers’ association’s London Interbank Offered Rate (LIBOR), the rate at which banks loan money to each other, is a good indication of how risky is the world is seen to leading banks. In the case of the US dollar rate, there sixteen banks on the panel that determines the LIBOR (see here for a great description of how LIBOR is determined

The LIBOR is the beating heart of the interbank system, and reacts instantly to new information. However, it also shows how risk perceptions, and following these, a potential recession, come about.

The LIBOR rates for the first 29 days of September show this vividly. The line marked O/N (you can disregard the S/N as the graph is for USD) is the overnight rate at which banks are ready to loan money to each other – the shortest period of loan. The jump on 16th of September to the 18th indicates the flight to look at the jittery. The longer periods follow suit (1 week, 2 week, etc), as can be seen, but more moderately. The jump is dramatic, of course, but more ominous is the longer-term change that the graph reveals. First, LIBOR rates have moved up from about 2.5% to almost 4%. This indicates the higher degree of risk assigned to loans. This on its own is important, but even more telling is the spread of rates across the different periods. While on 1st of September, the range between the lowest and the highest rate was 0.8%, (not taking into account the very volatile overnight rate), the range on 29th of September is only 0.09%! This shows that not only that banks see their environment as riskier than before, but they also distinguish less between more and less risky loans. In fact, they tend to see all loans, regardless of the period for which they were taken, as risky. Such, diminished distinction is a sure sign of flight to liquidity – institutional risk avoidance, but it is also a reflection, if it continues, of a slowdown in macroeconomic activity. If all loans are seen as high risk, less loans are going to be granted.

Posts in the last few days triggered so much good discussion in the comments that I thought that it would be a shame to leave it buried there. So, here is, with minimal editing, the discussion that Martha Poon and Zsuzui Vargha had here last week, following the bailout of AIG.

Whether a firm is “too large to fail” is in fact the outcome. I want to add that it’s not only about justifications but also calculation, as Yuval suggested at the end of the original post. In order to establish how “big” the firm is in terms of market worth (along the lines of Boltanski and Thevenot), the regulators have to trace or get a vague sense of what the network of contracts looks like, estimate the scenarios, assess the ripples. Another kind of calculation is about credibility. Regulators are always called upon being consistent, because markets have to be calculable, and calculability can only be maintained if actors’ responses are not random. This is both what Max Weber already suggested, and also the lesson from socialist economies with “soft budgetary constraints”. So, regulators have to prove that what they are doing is consistent-why they are saving AIG when they are not saving Lehman.

The justifications [for saving one institution but not saving the other] become inconsistent as they pile up on each other. At some points, however, the actors do look back on their decisions and try to justify how their current super-interventionist measures fit well with their earlier anti-regulatory position. In the most grand terms, Bernanke and Paulson try to say it’s a qualitatively different situation than the ordinary state of markets-it’s a state of emergency. Such a statement allows them to discard free market dogma, gives them carte blanche, and makes them problem-solving world-saving heroes. I wonder how accountability will or will not develop after the crisis is over. Bush managed to avoid it after 9/11.

Rapid change during this crisis makes the trial and error process of policy-making much more visible than otherwise. We literally see how the regulators are shifting justifications within 24 hours, from the case-by-case, now admittedly ad hoc way of addressing the crisis, to the “systemic” view of intervention.

What do you think about the following description? That this shift of frame means that the actors have given up calculating the consequences of each failing bank, it’s too complicated and they can’t identify the losers in advance, and they can’t bail them out as companies (that would really go against their anti-interventionist position). They are now calculating in terms of product market categories (what kind of debt should the government buy), which is not specific to the individual company. So they went from a firm-centered view of where the crisis is, to a market-centered one.

Daniel’s comment to my earlier post calls for another post…

About the ‘regimes of worth’ point: yes. This is the general idea I was aiming for, although you express it here in a more eloquent way. I would not, however, use the word ‘inconsistent’ here, but instead refer to the fundamental incompatibility of the different orders of worth. Also, we should not assume that the different regimes of value exist separately. Of course, Boltanski et al are more sophisticated than that and refer to the continuous cross-fertilisation (my expression) of the regimes, but this should be stressed. The SEC, the markets and an assortment of experts (economists, accountants, OR people and many others) were affected by each other all the time. This does not necessarily mean that the incompatibility is lessened now, but it is important to note that the representatives of the different regimes of truth, if you may, go through a dynamic of change.

About SSF and short selling: Hong’s point that short selling is another way to express a view about the market is correct, of course, the same way that leveraged derivatives, for example, allow market participants to take positions in the market without committing capital upfront. The important point, as you say, is that short selling may be ‘expressing’ the same market view as selling a stock, but the informational and technological impacts that the different tools/practices have on other actors and the market would be different.

I do not know what are the exact routes through which such effects ‘flow’, but the little I have some knowledge about shows that the ban on short selling may backfire in some unexpected ways. For example, a popular type of trading algorithm uses matrices of historical correlations between stocks. The basic operation of the algorithm is that it buys one stock, while shorting its ‘counterpart’, another stock that’s expected to go down during the expected horizon given to the position. We need to stress that this is not a hedging position but the algorithm’s ‘value maintenance’ background process. So, when the SEC banned short selling, such matrices are, in effect, shut. Of course, buying and selling the different pairs of stocks would amount to a similar effect of value maintenance, but at a much higher level of capital dedication. Even more importantly, from the SEC’s perspective, is the fact forcing algorithms to replace short selling with actual buying/selling may introduce potential ‘volatility time bombs’ to the market, when many algorithms will be buying or selling the same stocks.


(Big thankyou to Zsuzsi Vargha for a very important idea)

The ban on short selling jogs the historical memory and ghosts of event of the post 1929 crash appear. During the post crash discussions in Congress, discussions that led to the creation of the SEC, the practice of short selling was blamed as one of the causes for the crash. Regulations controlling short selling were included in the 1934 Act, and a rule banning short selling sharply dropping markets (the ‘up tick’ rule) was implemented.

Naturally, not having a historical perspective on the current events in the markets does not help us in making direct comparisons. However, when we examine the SEC’s press release announcing the ban, the fundamental regulatory worldview underpinning the move become visible and with it, the connections to the 1929 crash, the constitutive event of the SEC. For example, market makers and specialist will be exempt from the short selling ban. Market makers provide liquidity to the markets. Hence, it is little wonder that in such a move, intended to prevent illiquidity, market makers will be allowed to continue selling assets short. However, a closer look shows that not all market makers would be entitled to these exemptions: “we are providing a limited exception for certain bona fide market makers.”

The distinction implied above, between ‘bona fide’ liquidity-supplying, short-selling market makers and between risk-takers intensifies the connection between the early 30s of the last century and the event of last week. The connection does not stop at the actual ban on short selling, but goes much deeper. In fact, it touches some of the deepest roots that connect American culture financial markets: the ambiguity surrounding risk and moral behaviour in financial markets. This connection can be expressed in the following moral dilemma-type question: under which circumstance can risk taking can be considered acceptable, and under which should it be condemned?

The answer that emerged from the discussions leading the creation of the 1934 Act aimed at defining the moral boundaries of market behaviour: risk taking would not acceptable when the only motivation behind it is greed and when the consequences of such behaviour may affect adversely others. Anyone vaguely familiar with financial markets would see the inherent problems of this definition. First, greed is a major motivation in financial markets. It is not only accepted but also, in effect, celebrated there. Penalizing greed in the market would be equal to giving speeding tickets at the Indy 500 (as was mentioned in a different context). Second, in the market there are countless situations where one’s actions affect negatively the wellbeing of others. In fact, the fundamental practice implied in stock options is of a zero-sum game: repeat bets on the price of the underlying asset where one’s gain equals exactly to another’s loss.

The above definition and its inherent difficulties have a long regulatory history. Obviously, this cannot be unfolded here, but a good place to start would be to trace the SEC’s releases related to rule 11a1-3(T) of the 1934 Act, a rule that defines and govern the conduct with regard to bona fide hedging. The history of this rule, which is a dimension in the history of moral behaviour in markets, provides us with a basis for comparison between the current market environment and between the one that existed the last time a comparable ban on short selling existed – in the 1930s. While in the 1930s, traders were the ones demanded to internalise and activate the moral code of conduct, today this demand is directed at a much more diversified group of market participants.

That group, among others, includes programmes and network experts who design and operate trading algorithms. The exact figure is not known, but it is estimated that about 30% of the short selling transactions in SEC-regulated market are conducted through such algorithms. This is not simply a ‘technical matter’ of programming the new requirement into the Direct Market Access ‘boxes’, as they are nicknamed. So, while the set of normative demands related to bona fide hedging can be understood, debated and followed in a meaningful manner when we are dealing with human market makers, what meaning would it have when machines are expected to behave morally?

Martha’s post (and particularly, the reference to the FT’s decade of moral hazard) made me think about the notions of moral hazard and systemic risk from a sociological perspective. From a financial economic perspective, moral hazard and systemic risk are categorised as different ‘species’ in the markets’ ecosystem: the former is mostly a bilateral risk while the latter is, well, systemic. However, when looked at sociologically, an interesting connection may appear.

Moral hazard may affect mostly bilateral contractual connections, but its source is rooted in a widely accepted, acted-upon belief or what Bourdieu would have called a field. Continuing Bourdieu’s lexicology, in the case of moral hazard, the field in which many financial actors seemed to have operated included the following habitus: counterparty to a financial contract would have a reason to believe that they can default on their contractual obligation and not suffer the consequences of that action, as the governmental regulator would step in. Of course, not just any actor in the financial market could develop and maintain such habitus. The events of the last few days show us that not even big and well-respected players, such as Lehman Brothers, could count on a bailout.

What is it, then, that allowed AIG to be saved and left Lehman Brothers to the market forces, that is, to go bankrupt? This brings us to systemic risks, or as the case may be, the lack thereof. Maybe the demise of Lehman Brothers was a result of a miscalculation on their part. That is, maybe they assumed that they were big enough to pose systemic risk in case of failure, but they were, in fact, ‘less than systemic’.

Which brings us back also to AIG. Is it the case that AIG was really too big and constituted too many inter-connections to be allowed to fail? The answer, as everyone can recite by now, is a resounding ‘yes’. The collapse of AIG would have been the crystallization of a systemic risk scenario and the Federal Reserve would not have allowed it to unfold. There is no denying that AIG plays a major role in the market’s immune system, as it were. Its share in default protection contracts is substantial. However, it is not only the actual market share that turned AIG into a potential systemic risk; it was the fear, fuelled by uncertainty, about who exactly were the ‘infected’ counterparts of AIG and to what extent they were affect, that drove the Fed to give AIG the unprecedented loan. The Fed, like many other market participants, regulatory and otherwise, is playing in the field of financial markets not according to a fully prescribed set of rules, but more through acknowledgments achieved through practice-based trials and errors.

Most attention, at least in the mainstream media, is directed at the potential ‘leakage’ of the crisis from financial markets to other parts of the economy. The most likely avenue for such leakage according to the media is through AIG. A potential demise of AIG, a major player in the re-insurance field, would send a shock to insurance market and would affect dramatically the premiums that business pay, even if they were insured through insurers other than AIG. This assumption is correct, but what seems to be neglected is that default risk is already commoditized and there exists a very active market for default derivatives (credit-default swaps, or CDS): contracts that give their owners a protection against the default of a specific entity. Hence, the prices of such contracts can indicate whether and to what extent the crisis has leaked to the economy at large. It has to be noted that there exists no central market for default swaps, as it is an area of unregulated OTC trading. Still, there are enough market makers in CDS to provide a picture. For example:

Credit-default swaps on Morgan Stanley soared 194 basis points to 458 and Goldman Sachs jumped 122 basis points to 321, according to CMA Datavision prices. Sellers demanded 50 percentage points upfront and 5 percentage points a year to protect the bonds of Washington Mutual Inc. from default on concern that the biggest U.S. savings and loan won’t survive the credit crisis, CMA data show. That compares with an upfront cost of 40 percentage points on Sept. 12 and means it would cost $5 million initially and $500,000 a year to protect $10 million in bonds for five years.

Note: it is true that AIG is a major seller in this market too, and if it goes under it will put the market into an imbalance. Yet, I would dare to say that here AIG is more a symptom than the main cause, as it seems that the problem is not specific to certain companies and that lack of confidence is translated very efficiently to illiquidity.

In attempt to inject liquidity into the anxious markets, the Fed softened its conditions for extending credit:

The Federal Reserve widened the collateral it accepts for loans to securities firms to include stocks in an effort to help Wall Street weather Lehman Brothers Holdings Inc.’s plans for bankruptcy.

This is a daring move, but a very risky one too, as it opens a door to a vicious circle. The markets where the stocks used as collateral are traded are the same markets that are now recording sharp drops… So, the collateral that will now be offered to the Fed for the loans will possibly be worth less, indeed, a lot less, than the loans against which it offered. In fact, if the securities firms use the loans to restore liquidity in the markets (and this is a big ‘if’) then prices will be established at lower level. Hence, even in such a situation, the Fed will be left with under-collateralised debts on its balance sheet. If that reminds you of the sub-prime crisis then you are not alone.

The choice of Sarah Palin as John McCain’s running mate seems like a stroke of political genius.  A beaming picture of perfection, the hockey mom and mother of five who talks like the woman next door may well do wonders to consolidate a segment of the conservative Republican base.

It’s important to point out however, that Sarah Palin is not ‘a woman’ (i.e. a generic model).  She is very particular kind of woman.  Her type is called the ‘superwoman’, a feminine being who effortlessly balances both a full time career and traditional domestic duties such as child rearing.

Plenty of sociological studies (for example the work of Arlie Russel Hochschild in ‘The Second Shift’ and ‘The Time Bind’) show that this woman does not exist in middle America.  If this was the dream of a certain generation of early feminists, when submitted to the empirical test, the idea that women can ‘do both’ and ‘do everything’ has rapidly fallen away.

So while she may appeal to a swath of middle conservatives who still herald the superwoman as the-woman-to-be, the middle women who are in a position to actualize this model will immediately recognize that she is false and unattainable.

So will that other segment of so-called elite women who have pursued high-powered careers.  Palin may have fired the gubernatorial chef, but she didn’t tell us who actually prepares her family’s meals.  Certainly not her if she’s busy campaigning, solving the energy crisis and dealing with national security.

Why does this point deserve its place on a ‘social studies of finance’ blog?  Because the financial situation of Americans will have a lot to do with who really identifies with Sarah Palin.

The U.S. is in a period of deep economic crisis it seems doubtful that that US families dealing with unemployment, divorce and overindebtedness are trying to live up to outdated cultural standards such as those projected by the Palin family.  Idealism prospers in times of prosperity, but in times of discomfort the bottom line is pragmatic.

If theories of practice are correct, ‘American families’, that most revered category of US voters, are struggling to forage new models to meet the challenges of contemporary family finance. In this electoral environment Palin’s image of woman and family may prove to be all but politically irrelevant.