The Credit Crisis as a Problem in the Sociology of Knowledge

Donald MacKenzie

November 2009

Authors address: School of Social & Political Science University of Edinburgh Chrystal Macmillan Building Edinburgh EH8 9LD Scotland D.MacKenzie@ed.ac.uk

The Credit Crisis as a Problem in the Sociology of Knowledge

This article examines the role in the current credit crisis of evaluation cultures (shared beliefs, practices, ways of calculating, and technical systems that are employed when market participants evaluate financial instruments) and metadevices (relatively durable configurations of social relations and technical systems, such as the canonical mechanism, largely identified by Carruthers and Stinchcombe, and the credit ratings system). Employing documentary sources and a set of 55 predominantly oral-history interviews, the article presents a historical sociology of the two categories of financial instrument crucial to the crisis (ABSs, asset-backed securities, and CDOs, collateralized debt obligations), and in particular discusses the evaluation of and the role played by a fateful concatenation of the two, ABS CDOs.

Introduction
The credit crisis that erupted in summer 2007 and culminated in the global banking crisis of fall 2008 stands in need of detailed sociological analysis.1 This article locates the roots of the crisis in the processes by which market participants evaluate financial instruments. It presents a historical sociology of the development and evaluation of the two key categories of financial instrument in the crisis: ABSs (assetbacked securities) and CDOs (collateralized debt obligations).

Valuing financial instruments is both difficult many of them, for instance, are claims on uncertain income streams that may stretch into the indefinite future and crucial.2 For example, Carruthers and Stinchcombe point out that a liquid market one in which there are plentiful transactions, at prices close to a known market price depends upon at least a degree of shared beliefs about the characteristics of the commodities being traded: liquidity is, among other things, an issue in the sociology of knowledge (Carruthers and Stinchcombe 1999, p. 353). These beliefs can, for instance, include a degree of commonality in participants understanding of the value of the assets being traded. The point may seem paradoxical, in that it may seem that there would always be more buying and selling if there were wildly discrepant valuations, but one of my interviewees nicely expressed the contrary intuition:

For existing sociological work on the crisis, see, e.g., Davis (2009, especially pp. 222-34) and the

May 2009 rapid response section of Sociological Research Online (http://www.socresonline.org).

2

Amongst the heterogeneous body of work demonstrating the importance and richness of evaluation

more generally as a topic for economic sociology are Boltanski and Thvenot (2006), Beckert (2007), Karpik (2007), Aspers (2009), and Stark (2009).

3 If youre going to buy a house, and someone [an appraiser] said to you, thats 1 million, and someone else [another appraiser] said, thats 600,000, and someone else said, thats 1.5 million. Youd be less willing to buy the house than if someone said to you, thats 1 million, thats 995 [thousand], thats 1.05 [million].

Full agreement amongst all market participants on the exact monetary value of a financial instrument is rare.3 Nevertheless, pockets of local consensus on how financial instruments should be valued can certainly be found. They form what I call evaluation cultures.4 These are shared sets of beliefs, practices, ways of calculating, and technical systems employed by market participants when evaluating financial instruments. Although empirical research on evaluation cultures is sparser than might be desired amongst this articles objectives is to encourage it by demonstrating their role in cataclysmic economic events a number of exemplary studies do exist, amongst them the fine ethnography of a New York arbitrage trading room by Beunza and Stark (2004) and the insightful historical study of chartism by Preda (2007).5 Those studies indicate that evaluation cultures are indeed not allencompassing (chartist practices remain widespread even though most financial

I set aside here the relatively common case in which participants are agreed that an instrument has no

value because the income stream on which it is a claim has ended and has no prospect of resuming.
4

I use this term, not valuation cultures, because I want to encompass forms of evaluation, such as

credit rating, that are drawn on in determining economic value, but do not themselves directly generate an estimate of value.
5

Arbitrage is trading that exploits price differences that arise, for example, from discrepancies in

others valuations of pairs of similar instruments. Chartism is the prediction of future price movements based on the identification of patterns in graphical representations of prices.

4 economists regard them as akin to astrology), and can often be quite local. Beunza and Starks ethnography demonstrates the (productive) friction among competing principles of arbitrage (Stark 2009, p. 16) at work even in a single trading room. Nor is there any reason to conceive of different evaluation cultures as wholly distinct, to assume that any given individual can be a member of only one of them, or to imagine that market participants unreflexively embrace the beliefs and act out the practices of a culture.6

Nevertheless, for the notion of evaluation culture to be more than simply a convenient shorthand, such cultures must have some coherence and some continuity through time. Furthermore, for variation between evaluation cultures to be of sociological interest it must reflect more than simply differences between the characteristics of different categories of financial instrument. Thus the two main categories discussed here, ABSs and CDOs, are structurally very similar, and are sometimes simply lumped together.7 Yet, as we shall see, some aspects of how they were evaluated were radically different.

Evaluation cultures are material cultures, encompassing not just the ideas and the actions of human beings, but also artefacts and technical systems. Most market participants can perform only the most rudimentary evaluation of financial instruments in their heads. They need tools pencil and paper, calculators, graphs

Multiplicity and reflexivity, and the cognitive and organizational ecologies that foster them, are

major themes of Stark (2009).

7

See, e.g., McDonald and Robinson (2009), which refers to both ABSs and CDOs as CDOs (p.

106n).

5 and they need data that are usually distributed via technical systems, such as the stock ticker discussed by Preda (2006).8 Nowadays, as Knorr Cetinas work vividly demonstrates, evaluation is an activity conducted in large part on computer screens, using extensive streams of electronic data, visual representations, and other programs (see, e.g., Knorr Cetina and Bruegger 2002a, b; Knorr Cetina 2005).

Attention to the material, sociotechnical aspects of markets has been fostered above all by the actor network economic sociology of Michel Callon, with its emphasis on market devices, in other words material and discursive assemblages that intervene in the construction of markets (Muniesa, Millo, and Callon 2007, p. 2). Amongst those devices, for example, are the economic models that market participants employ. Such a model, insists Callon (1998 and 2007), is not simply a representation. It is performative: it contributes to and shapes market processes. Sometimes, the effect is to make those processes more like the postulates of the model. At other times, though, the practical use of a model can make it empirically less accurate, a phenomenon (present in the episodes discussed in this article) I call counterperformativity.

Two hazards attend a focus on market devices. The first is the implicitly reductionist view of culture sometimes found in actor-network theory: culture as the circulation of texts, images, and other physical entities. The notion of evaluation culture includes this circulation, but also encompasses what does not circulate:

Some market participants can mentally estimate the output even of something as sophisticated as an

option pricing model, but this capacity seems to come from long experience of the use of such models rather than extraordinary powers of mental arithmetic (author ref.).

6 shared, tacit evaluations; the calculations that are not made; the things that are not spoken of (including Bourdieus complicitous silence);9 the people who are not spoken to; and so on. The two evaluation cultures on which this article focuses (that surrounding ABSs and that surrounding CDOs) differed in ways that were clear and explicit, but also in subtler ways, as witnessed by the occasional implicit disparagement by members of the CDO culture of the level of mathematical sophistication of the ABS culture, or in the reluctance on the part of professionals in the areas of CDOs and structured credit to seek and accept input from ABS/MBS experts (Adelson and Jacob 2008b, p. 8; MBS is the acronym of mortgage-backed securities, which are the main class of ABSs).

The second hazard lies in the more limited meaning in ordinary usage of device than of the French original, dispositif, with (at least amongst social scientists and historians) its now inescapably Foucaultian connotations: What Im trying to pick out with this term is, firstly, a thoroughly heterogeneous ensemble consisting of discourses, institutions, architectural forms, regulatory decisions, laws, administrative measures, scientific statements, philosophical, moral and philanthropic propositions Such are the elements of the [dispositif]. The [dispositif] is the system of relations that can be established between these elements. (Foucault 1980, p. 194)

The most successful ideological effects are the ones that have no need of words, but only of

complicitous silence (Bourdieu 1990, p. 133; see Tett 2009b).

7 Accordingly, it is worth having a way of referring not just to specific devices in the ordinary sense of the term, but to sociotechnical configurations that have some durability (in the sense, for example, that the configuration persists even when the component devices change) and at least some of the wider force of the Foucaultian dispositif.10 I will refer to these configurations as metadevices, and the article identifies two, which are discussed in the next section: the canonical mechanism (largely identified by Carruthers and Stinchcombe 1999) and the credit ratings system. (Two others, which for reasons of space are touched on only very briefly, are accounting, specifically financial reporting, and the regulation and supervision of banking.)

The research reported in the article is a historical sociology of the development of and evaluation cultures surrounding ABSs, CDOs, and a crucial concatenation of the two, ABS CDOs. Even though these instruments are in the main relatively new (for example, the first ABS CDO dates only from 1995), a historical approach is needed because how those instruments emerged is important and because the evaluation cultures surrounding them were historically shaped. ABS CDOs, for example, are at the very heart of the credit crisis by October 2008, losses on them, as calculated by the IMF, had reached $290 billion, the largest single category of loss suffered by the global financial system (IMF 2008, p. 9) and, for all their novelty, one cannot understand them without understanding the development paths of ABSs, of CDOs, and of their (quite different) evaluation cultures, including the different ways the two metadevices the canonical mechanical and the ratings system articulated at different points in time.

10

See also Karpiks dispositifs de jugement (2007).

8 This is not an area in which the historical sociologist can rely on existing historical work: the occasional brief historical accounts in publications by practitioners are sometimes unreliable and always need checked against primary sources.11 Accordingly, the account that follows draws extensively on two main sets of primary sources. The first is 55 interviews conducted by the author, mainly in either London or New York, with 52 market participants,12 including 22 who are or were arrangers, managers, brokers, or traders of the financial instruments discussed in this article; 13 who are quants (specialists in quantitative modeling); nine who are or have been rating-agency employees; and four who are or were market regulators.13

11

The single most valuable existing account is Tett (2009a). There is also a useful treatment of the

development of credit derivatives in Huault and Rainelli-Le Montagner (forthcoming). Of historical value because conducted before the credit crisis is the one existing ethnographic study of ABS and ABS CDO construction and evaluation, Ortiz (2008). Neil Fligstein and Sarah Quinn (also of the University of California at Berkeley) are currently working on mortgage securitization in the US, including its early development.
12

Four interviews were with two market participants, and two involved three interviewees. Eleven

participants were interviewed twice. In one case this was because the initial interview was curtailed; the other ten cases were participants originally interviewed before the credit crisis who were reinterviewed after its onset.
13

The remaining four interviewees were selected in order to gain insight into specific aspects of the

market: two provide hardware on which computationally intensive models are run; one works for a firm specializing in provision of price data; and one is an accountant with specialist knowledge of accounting for financial instruments. There is, of course, overlap between the categorizations in the text: thus at least two of the rating agency employees could also be classed as quants.

9 The interviews generally14 took a loosely oral history form, in which the interviewees were led through those parts of their careers in which they had been involved with the financial instruments examined here. Questioning was semi-structured, and designed to elucidate the evolution of the relevant market and the main innovations and forms of evaluation in it. No claim of statistical representativeness can be made: there is no list of individuals involved in the ABS or CDO markets that can be sampled and access is often difficult or impossible to negotiate, so the sample was constructed by snowballing from an initial set of interviewees identified via documentary sources. Furthermore, oral-history interviewing has notorious pitfalls: interviewees may have fallible memories, and may wish to promulgate particular views of episodes in which they were involved, especially in the aftermath of a disaster such as the credit crisis. (The first interviews in fact predate the crisis: they were conducted, in a preliminary pilot study, between April 2006 and May 2007.)

The second source of primary data, contemporaneous documents, was therefore also valuable, both in its own right and as a means of triangulation. These documents included the specialist trade press, such as Credit and Creditflux (and, for more recent years, in which the ABS and CDO markets have become much more prominent, the wider financial press, notably the Financial Times and Wall Street Journal), and the technical literature on ABSs and CDOs, such as documents in which the credit rating agencies described the models used to rate these instruments. (Though those latter documents do not provide, e.g., a complete record of the precise numerical values of the

14

Nine of the interviews focused solely on a single issue or single point in time, either because that was

the purpose of the interview or the interviewees only relevant role, or because time constraints made it impossible to range more widely.

10 parameters employed, they are nonetheless a vital source.) Amongst other helpful documentary sources are, for example, a set of reports on ABS industry conferences from 2001 onwards produced by analyst Mark Adelson and his colleagues at Nomura Securities.15 Although one should not be naive about such meetings selling to potential investors is a major goal Adelsons reports are amongst the few remaining records of the flavor of informal discussions, largely amongst specialists, in what is now a lost world: ABSs before the catastrophe that became apparent in the early summer of 2007.

Because of the need to construct a historical narrative largely afresh, this article is inevitably lengthy. It is also inescapably somewhat technical, for which I make no apology: the roots of the crisis lie deep in the sociotechnical core of the financial system. The article has seven sections. After this introduction comes a section on the two metadevices, the canonical mechanism and the ratings system. The third section begins the narrative with the modern origins of asset-backed securities in the initially government-sponsored securitization of residential mortgages in the US from 1970 onwards, and discusses the evaluation culture that developed around this. The fourth section performs a similar task for the original CDOs, in which the underlying assets were bonds issued by corporations or loans made to them. I refer to such CDOs as corporate CDOs, so as to distinguish them from the somewhat later ABS CDOs (CDOs in which the underlying assets were ABSs, mainly mortgage-backed securities, not corporate debt), which are discussed in the fifth section. The sixth section discusses why putting assets with an almost impeccably default-free history (mortgage-backed securities) inside vehicles (CDOs) with a less impressive, but still respectable, record

15

These are available at www.adelsonandjacob.com.

11 should have triggered processes that came close to causing the collapse of the global financial system. The seventh section is the articles conclusion.

Two Metadevices: The Canonical Mechanism and the Ratings System

The most important metadevice by which knowledge of financial instruments produced is what I call the canonical mechanism, most of the features of which have been identified by Carruthers and Stinchcombe (1999).16 In it:

1.

The instruments in question are standardized and homogeneous; they are equal claims on an income stream (Carruthers and Stinchcombe 1999, p. 353).

2.

They are bought and sold in continuous double auctions, i.e. auctions in which sellers submit competing offers to sell as well as buyers submitting competing bids to buy.

3.

Continuity of the auctions and thus of the market price is maintained either by use of a central computerized order-matching system (as, for example, in the case studied by Muniesa 2005) or by the actions of human marketmakers (such as the

16

Carruthers and Stinchcombe treat items 1, 2, and 3 of this list as three mechanisms, while I would

regard them as three aspects of a single mechanism. Item 4 is implicit in their analysis, but is important enough (see the next note) to merit highlighting explicitly. The precise form taken by auctions is also important enough for it to be worth specifying that the canonical form is a continuous double auction.

12 New York Stock Exchange specialists examined by Abolafia 1996), whose role obliges them continuously to quote a price at which they will buy and a price at which they will sell the instrument in question.

4.

Prevailing market prices are made available not just to the parties to a transaction but to market participants more generally.

Although the markets that trade the shares of large corporations or the benchmark bonds issued by major governments are reasonable approximations to the canonical mechanism, it should be emphasized that it is an ideal type. For example, prior to computerized order-matching, few auctions were genuinely continuous; in times of severe market stress, marketmakers sometimes stop quoting prices; exactly which prices are disseminated, in what form, to whom, and when can all be hugely consequential.17 Nevertheless, it is a powerful ideal type. Orthodox financial economics holds that the price of a financial instrument in a canonical-mechanism market is the best estimate of that instruments value (that is one way of phrasing the fields efficient market hypothesis).18 Typically, only a minority often quite a small minority of market participants share that view, with the majority inhabiting evaluation cultures, such as fundamentals analysis, which believe that their practices generate estimates of value

17

Apparently technicalities such as tick size (the minimum permissible price change) and (in

electronic trading) speed of connection to the computer servers that perform order matching can matter a great deal: see (author ref).
18

The classic formulations of the hypothesis (such as Fama 1970) do not in fact specify the forms of

market in which it is believed to hold, but most of the underlying empirical work is on canonicalmechanism markets.

13 that are better than market prices (see, e.g., Smith 1981), and indeed if that were not so canonical-mechanism markets would see much less trading than they actually do.19

Nevertheless, even for that majority the canonical mechanism generates prices that are treated as legitimate. Whether or not a specific quoted price is fair can quickly and easily be checked by comparing it to trusted reports of the prevailing market price; indeed, such is the canonical mechanisms legitimacy that in the stockmarket many participants have often been content to submit market orders: orders to buy, or to sell, at the prevailing price (Smith 1989, p. 65). Traces of the mechanisms hegemony can also be seen in the forms of dissent that are credible. For instance, when market participants disputed whether prices in two of the markets discussed below, the ABX and TABX, were reliable guides to the value of subprime credit derivatives, they did so not by arguing that canonical-mechanism markets do not generate fair prices, but by claiming that the ABX and TABX were not, in fact, proper canonical-mechanism markets. (Credit derivative is the generic term for CDOs, the credit default swaps discussed below, etc.)

For all the unparalleled cultural and indeed political legitimacy of canonicalmechanism markets, they are not all-pervasive, even in finance. Making financial claims standard and homogeneous can require dauntingly difficult minting work (Carruthers and Stinchcombe 1999, p. 365), and powerful actors may not wish a canonicalmechanism market to be created. (The brokers and marketmakers interviewed for this study frequently reported that non-standard instruments offered much higher profit per

19

Hence the irony that the large trading volumes that help make markets efficient are generated in good

part by those who believe them not to be efficient.

14 unit than standardized ones, though they also noted that standardization usually led to substantially higher volumes of trading.) When a financial instrument is not traded in a canonical-mechanism market, participants cannot simply check its market price: no similar enough instrument may have been traded previously, at least not recently, and even if one has been its price may remain the private knowledge of the buyer and seller. Accordingly, those who trade non-standardized instruments need other means of valuing them.

The most important alternative metadevice they turn to is the ratings system. Credit rating agencies specialize in evaluating credit risk: the risk of borrowers (corporations, municipalities, governments, etc.) defaulting on their obligations to repay their debts and/or make timely interest payments.20 Their original core business was rating the creditworthiness of corporations, especially those that issued bonds, a business that in the post-war US was dominated by two agencies, Moodys and Standard & Poors (S&P). From the late 1970s and early 1980s onwards, those agencies also rated the financial instruments discussed here, and in the 1990s a third agency, Fitch, became an effective competitor in this market.21

- FIGURE 1 AROUND HERE

20

A different set of organizations, such as FICO (the Fair Isaac Corporation: see Poon 2007 and 2009,

and Rona-Tas 2009), specialize in assessing individuals creditworthiness.

21

Despite the pivotal role the rating agencies occupy, there is much less social-science literature on

them than might be expected. The single source that is most useful overall is Sinclair (2005), but unfortunately that does not deal with the rating process for the instruments discussed here; there is also important as-yet-unpublished work by Bruce Carruthers and Barry Cohen on the role of credit ratings in the late nineteenth-century US.

15

Credit ratings are a hierarchical scale of categories of assessed credit risk (see figure 1). The agencies emphasize that a rating is an opinion on relative creditworthiness, not a valuation, but ratings permitted investors quickly and easily to evaluate a new and unfamiliar instrument by comparing the spread22 it offered to that offered by more familiar instruments, such as government or corporate bonds, with the same rating. It was common, for example, for the AAA-rated tranches of CDOs to offer spreads of between 15 and 60 basis points over Libor (London Interbank Offered Rate, the main international interest-rate benchmark), while the yields of AAA government bonds or the relatively few corporate bonds with AAA ratings would usually be below Libor. 23 Lower-rated CDO tranches would also offer somewhat higher spreads than those of conventional bonds with the same rating. It therefore seemed to many investors that the new instruments offered better value (a higher rate of return for similar credit risk) than corporate or government bonds. In the words of a dealer who constructed these instruments, You knew that if you hit a certain spread for a given rating, that the deal was sold (quoted in Securities Industry and Financial Markets Association 2008, p. 22).

The reason I use the term ratings system is that more was involved than merely the rating agencies. Upstream of the latter, those who constructed ABSs and CDOs had how they would be evaluated by the agencies firmly in mind, in a manifestation of what Espeland and Sauder (2007) call reactivity: the effects of evaluating or ranking on what is being evaluated or ranked. Downstream, investors were disciplined by ratings, not

22

The interest payments offered by the instruments discussed in this article are usually thought of

(and often set) not as fixed percentages but as spreads (increments) over a benchmark interest rate.
23

A basis point is a hundredth of a percentage point. On Libor, see author ref.

16 because the rating agencies wished it to be so, but because regulators and trustees found ratings a convenient tool for specifying what it meant to be prudent. Cantor, ap Gwilym, and Thomas (2007, p. 14) note that in the US there are currently over 100 federal laws and 50 regulations incorporating credit ratings, and they report that the purchases of 74 percent of their sample of US investment fund managers (and 78 percent of European managers) were subject to a minimum-rating requirement: if an instruments rating was below the latter, they were not allowed to buy it.

A financial instruments rating thus has effects even if investors do not believe it to be a correct representation of the instruments credit risk. An investment manager might, for example, believe that an instruments BB rating exaggerates its risk, but if her mandate excludes instruments that are not investment grade she cannot act on that belief. Or a manager may have thought that a AAA ABS CDO tranche was actually riskier than a AAA government or corporate bond, but still have chosen to invest in the CDO tranche anyway, because it offered a higher spread and her performance was being measured by the returns she achieved while managing a portfolio with a desired ratings profile.

I suggested above that to qualify as a metadevice a configuration of devices needs durability, and the credit crisis is a good test of that. It has enhanced the canonical mechanisms status: much current regulatory effort is being devoted to extending its scope, for example by further standardizing credit derivatives. The ratings system, though buffeted, has survived. As the next section describes, securitization began its modern history as a government program, and it is now a government program again. In the absence of investor confidence, governments are guaranteeing securitizations, and central banks are buying ABSs or accepting them as collateral for loans. With little

17 inhouse expertise in the evaluation of complex financial instruments, governments and central banks are typically accepting only AAA instruments for these programs, and so ratings remain crucial to the capacity of banks to continue to finance their lending.

Securitization: Creating and Rating Asset-Backed Securities (ABSs)

ABSs are created by the process of securitization. The bank or other organization that is arranging a securitization normally sets up a legally separate special-purpose vehicle usually a trust or a new, special-purpose company which buys a set of mortgages or other income-generating assets. (Frequently the assets are loans the arranger has made.) The vehicle sells investors securities that are claims on the income stream from those assets (for example, on the interest payments and principal repayments from the pool of mortgages), and uses the proceeds of the sale of these securities to pay for the assets.

Although it had loosely analogous predecessors in earlier times and other places, the modern history of securitization in the US began in the late 1960s and 1970s, with Federal government efforts to increase the availability of mortgage finance and reduce its cost. Three government-sponsored enterprises Ginnie Mae (the Government National Mortgage Association), Fannie Mae (the Federal National Mortgage Association), and Freddie Mac (the Federal Home Loan Mortgage Corporation) played key roles. Ginnie Mae gave a government guarantee to securities backed by pools of mortgages (starting with Ginnie Mae Pool No. 1, issued in February 1970, which consisted of $7.5 million of modestly-sized mortgages originated, primarily in Minnesota, by finance company Tower Mortgage). In 1971, Freddie Mac started to sell securities based on pools of mortgages it

18 had itself purchased; Fannie Mae began to do so in 1981. By 1991, Ginnie Mae had guaranteed, and Freddie Mac and Fannie Mae had issued, a total of just over a trillion dollars of mortgage-backed securities (Carron 1990; Tower 1999; Fabozzi and Modigliani 1992, pp. 18-24).

Three features of this context of origin were to have lasting effects on the way mortgage-backed securities were evaluated. First, Ginnie Mae, Fannie Mae, and Freddie Mac set minimum quality criteria for the mortgages they would guarantee or buy, thus defining conforming or prime mortgages. Second, because they guaranteed investors in mortgage-backed securities against defaults on the underlying mortgages, and since the full credit of the US government was seen as standing behind the three enterprises, investors treated their securitizations as involving no credit risk.24 Third, however, these securitizations did involve prepayment risk. The holders of securitized mortgages were free to redeem their mortgages at any point, and large proportions of them did so (for example, in the final months before Ginnie Mae Pool No. 1s thirty-year maturity, its remaining pool consisted of only ten unredeemed mortgages: see Tower 1999). Investors received a pro-rata share of the redemption sums, but from their viewpoint prepayment counted as a risk, not a benefit, because mortgage-holders tend to prepay when interest rates are low (and attractive opportunities to refinance mortgages are available). Investors thus tend to receive their money back at precisely those times when it can be reinvested only at lower rates of return. Assessing this prepayment risk was traditionally seen as the crucial issue in valuing mortgage-backed securities.

24

In fact only Ginnie Mae guarantees were legal obligations of the Federal government, but investors

generally took the government implicitly to stand behind Fannie Mae and Freddie Mac as well.

19 Despite the risk of prepayment, the US government-sponsored mortgage-backed securities market was very successful: it is one of the two main examples offered by Carruthers and Stinchcombe (1999) of how standardization and the creation of impersonal knowledge of financial instruments promotes market liquidity. In 1977, the first modern private label (not government-sponsored) US mortgage-backed securities were issued by the Bank of America (Carron 1990), and the 1980s saw rapid innovation. The early securities (known as pass-through certificates) offered identical, equal shares of the cash flow from the underlying mortgages; they were joined from 1983 by collateralized mortgage obligations in which Ginnie Mae and other mortgage-backed securities were repackaged into instruments that carried different exposures to prepayment (Lewis 1990, pp. 136-38). Other types of consumer debt, in particular from 1985 onwards auto loans and credit-card receivables, also began to be securitized (Rosenthal and Ocampo 1988, table B.1), and the generic term ABS (asset-backed security) came into use to describe the products of these securitizations.25

With private-label mortgage-backed securities and other ABSs carrying no government guarantee, the issue of credit risk of borrowers defaulting could no longer be set aside. The most important single means by which it was taken into account was tranching. Instead of issuing a single class of pass-through certificates, the special purpose vehicle sold two, three, or more classes or tranches of securities differentiated by credit risk, as in figure 2. The lowest tranche bore the first losses caused by default on the pool of mortgages or other assets underpinning the securitization. In early private-

25

Usage of the term ABS is not consistent through time. Only once subprime mortgage

securitizations became popular did it start to include mortgage-backed securities, and even then securitizations of prime mortgages were not generally referred to as ABSs.

20 label securitizations, this tranche was typically retained by the arranger of the securitization; later, it was often sold to outside investors, who received a large spread (increment over Libor or other benchmark interest rate) for taking on a substantial risk of loss of the capital they invested.

- FIGURE 2 AROUND HERE -

Only if defaults rose to such a level that losses entirely exhausted the lowest tranche were the investors in the next tranche, which came to be called mezzanine, at risk. Again, in early securitizations this tranche was also often retained by the arranger. It would typically be larger than the lowest tranche perhaps as much as eight times as large (Rosenthal and Ocampo 1988, p. 10) which meant that losses on it could seriously damage the arranger. However, because the cushion provided by the lowest tranche made the probability of mezzanine losses modest, the arranger could buy insurance against them from the specialist bond insurers known as monolines, whose original business had been insuring US municipal bonds. At the top of the hierarchy of tranches was the senior tranche, which was always sold to outside investors. With both the lower tranches as buffers, the risk of loss on the senior tranche was very low. Accordingly, only relatively modest spreads were thought necessary to compensate for this small risk.

How, however, was an investor to value a tranche of an ABS? Although there certainly were structural similarities between different securitizations (once a successful structure had been found it was often copied widely, since financial innovation cannot in general be patented: see author ref.), the asset pool of each would be different. Nor were

21 tranches traded at all regularly: most investors simply bought them and held them until they matured and their capital was returned (see, e.g., Ortiz, 2008). So the standardization and continuous trading required by the canonical mechanism were absent. Only the most basic techniques for modeling the credit risk involved in securitizations were available to investors in the 1980s, and many investors would in any case not have regarded an intensive modeling effort as cost-effective, because they saw ABSs as only a small part of a much larger, diversified portfolio. (The investors in ABSs and CDOs are nearly always institutions, such as banks, insurance companies, pension funds, moneymarket funds, hedge funds, and the like, not private individuals.)

Accordingly, the rating agencies came to play a pivotal role in securitization. S&P began to rate securitizations in 1978. Moodys was more hesitant (the characteristics of securitizations are very different from those of the corporate bonds in which the agencies were expert), but it too began to do so in 1983.26 The methods S&P and Moodys initially used were not the computerized simulations described in later sections but rules of thumb. Consider, for example, how Moodys rated tranched privatelabel mortgage-backed securities in the late 1980s (Bhattacharya and Cannon 1989). In those years, it would usually be only the senior tranche that was rated and sold to institutional investors at large, and the rating that was targeted was often Aa. The core of what Moodys did was a method of determining the level of credit enhancement required for the Aa rating. (A tranches credit enhancement is the total size of the lower tranches, guarantees, reserve funds, etc., that protect it from losses. From the arrangers viewpoint, all these mechanisms are expensive: e.g., if lower tranches are sold to outside

26

See the data tables in Roy and McDermott (2007); q.v. Cantor and Packer (1994, p. 20).

22 investors, the higher spreads required to attract them limit the spread that can be offered on the senior tranche.)

Moodys defined six benchmark pools of mortgages, each consisting of what would now be called prime mortgages but differentiated by loan-to-value ratio, and for each specified the credit-enhancement level needed for a Aa rating: the level for the benchmark pool with a loan-to-value ratio between 51 and 60 percent, for example, was 2.35 percent, while the riskier 91 to 95 percent pool required 5.35 percent credit enhancement.27 Deviations between the actual pool of mortgages underpinning a mortgage-backed security and these six benchmark pools would then lead to specified rule-of-thumb adjustments to those required credit enhancement levels, for example increasing them if the mortgages in the securitys pool were very large and decreasing them if the homes were located in regions that rank strong in industry diversification (Bhattarchya and Cannon 1989, p. 482). Note that the upstream aspect of the rating system, referred to in the previous section, is entirely explicit here. It is not that mortgage-backed securities were first produced and then rated. Rather, the securities themselves and knowledge of the securities were co-produced: the credit enhancement level, the crucial parameter in the design of a tranched security, was determined by the rules for awarding ratings.

Those rules were based as far as possible on historical experience. When, for example, S&P awarded AAA ratings to tranches of mortgage-backed securities, it used the US mortgage defaults of the Great Depression as the stress test: the credit enhancement of a AAA tranche had to be such that it would not suffer a loss even if
27

I draw these figures from the worked example in Bhattacharya and Cannon (1989, pp. 473-83).

23 default rates reached Great Depression levels (interview data; see also Khadem and Parisi 2007, pp. 546-47). After rating securitizations, the agencies monitored their subsequent performance. The results were reassuring: performance in general was excellent, with ABSs frequently outperforming corporate bonds with the same ratings. S&P, for example, found an average annual downgrade rate of AAA tranches of ABSs (from 1978 to 2004) of only 0.8 percent, compared to 7.36 percent for AAA corporates.28 The equivalent figures for Moodys (for 1983 to 2004) were 1.03 percent for Aaa ABSs compared to 8.32 percent for Aaa corporates (Roy and McDermott 2007, tables 11.5 and 11.9).

In particular, ABS defaults were rare, at least until 2001-2 (when a number of specific ABS sectors, such as securitizations of aircraft leases, franchise and manufactured housing loans, and mutual fund marketing and distribution fees, were hit by the aviation downturn after September 11, by recession, and by stockmarket falls).29 A February 2001 Moodys report noted that we often hear that no ABS security has ever defaulted (Harris 2001, p. 13). While not entirely consistent with the chronology of defaults in Erturk and Gillis (2005), the belief is indicative of widespread conviction in the safety of ABSs. Furthermore, the troubles of 2001-2 left the archetypal ABSs, residential mortgage-backed securities, largely unscathed. These securities had already acquired the reputation of being a remarkably stable asset class, and investors implicitly treated not just government-sponsored securitizations but also the senior tranches of

28 29

A downgrade is when an agency reduces the rating of a debt issuer or security. See Adelson (2003) and Perraudin and van Landschoot (2004). Manufactured housing is

prefabricated dwellings, notably mobile homes.

24 private-label mortgage ABSs as free of credit risk: they typically assume that principal will be returned with 100% certainty (Fabozzi, Bhattacharya, and Berliner 2007, p. 241).

Because that cognitive world has now vanished, it is necessary to emphasize the widespread nature of the implicit conviction that AAA-rated tranches of ABSs were ultra-safe. An interviewee put it like this (in January 2009): So 18, 24 months ago if you asked somebody what would happen to AAA ABS if people got spooked about the global economy, and you asked 99, 100 people in a survey who were pre-eminent experts in securitization, what would happen to AAA ABS, I would suggest to you that more than 95 out of the 100 would say, price would go up. The flight to quality, the desire to hold on to something which you know is risk-free. Riskfree is a term which [was] regularly used to talk about AAA ABS assets.

What securitization did, therefore, was to bring together investors who saw ABSs as generally safe, stable instruments, and thrifts, banks, or finance companies which either lacked the capital to fund their lending from their own resources or which wished to reduce the risks it posed to them. For example, much lending in the US was by lenders with either a limited geographical scope or expertise limited to specific industries. Their local knowledge was valuable, but heavy exposure to the economic fortunes of a specific region or particular industry was dangerous; securitization permitted much of that exposure to be passed on to institutional investors for whom any particular ABS formed only a small portion of a diversified portfolio (see, e.g., Rosenthal and Ocampo 1988, p. 8). Securitization enabled much higher volumes of lending than would have been possible if banks had been able to lend only the sums their customers had deposited: by

25 the time of the credit crisis, securitization funded more than half of all home mortgage lending in the US and a quarter of other consumer credit (Securities Industry and Financial Markets Association 2008, exhibit 17, p. 37). Plentiful lending helped US economic growth; indeed, eventually it became the dominant contributor to that growth, with housing and consumer expenditure estimated by The Economist as generating ninetenths of the increase in US GDP from 2001 to 2004 (anon. 2005, p. 75). By then, though, a new class of instruments, similar in structure to ABSs, but thought of very differently, had started to play a crucial role in the securitization market, and it is to those that we must now turn.

CDOs: Collateralized Debt Obligations

In the 1970s and most of the 1980s, securitization in the US mainly involved pools of residential mortgages and other loans made to individuals or couples. Given securitizations success, however, it is unsurprising that in the late 1980s it was extended to encompass pools of bonds issued by corporations or loans made to them, creating the category that became known as collateralized debt obligations (CDOs). Because mortgages are (in financial-market terms) small loans, it is common for an ABSs pool to contain around 5,000 of them, while the asset pool of a corporate CDO is lumpier: it usually includes the debt of around 100 to 150 corporations. In other respects, though, CDOs closely resembled ABSs: for example, the securities they issued were tranched in the way sketched in figure 1. As CDOs developed, however, that initial structural similarity masked increasing technical and cultural differences.

26 The asset pools of the first CDOs consisted either of junk (speculative-grade) bonds or of loans made to corporate raiders, to other highly-indebted corporate borrowers, or to commercial property developers (Lucas, Goodman, and Fabozzi 2006, p. 5). The first CDO I have been able to trace (using the data tables accompanying First Union Securities, Inc. 2000) was the $125 million Long Run Bond Corp., completed on November 1, 1988, and arranged by the investment bank Drexel, Burnham, Lambert, whose heavy involvement in the junk-bond market was famously led by Michael Milken. From 1996 on, however, CDOs became mainstream when they started being used on a large scale by banks to shed credit risk from their loan portfolios and to reduce the capital reserves that regulators insisted they hold in respect to that lending. In November 1996, the UKs National Westminster Bank completed a $5 billion securitization of its loan book known as Rose Funding (previous CDOs had typically been a tenth of that size or smaller). In September 1997, Swiss Banks Glacier Finance raised $1.7 billion and NationsBanks Commercial Loan Master Trust $4.2 billion, and the remaining months of 1997 saw further large CDOs created by, amongst others, Bank of Tokyo/Mitsubishi, Credit Suisse, ABN Amro, Rabobank, J.P. Morgan, and Sumitomo (First Union Securities, Inc. 2000).

The creators of this new wave of CDOs were usually not in banks mortgage or securitization departments but in the entirely separate derivatives teams that specialized in different products, notably interest-rate swaps (interview data; Tett 2009a).30

30

An interest-rate swap involves one party paying the other a fixed rate of interest on an agreed

notional principal sum, while the second party pays a floating rate (usually Libor) on the same sum. Introduced in 1981 (Beckstrom 1988, p. 43), interest-rate swaps quickly became widely used by banks and other market participants to manage the risks of interest-rate fluctuations.

27 Sometimes these teams discovered only accidentally that others in the same bank had long experience of similar structures. One interviewee from the world of derivatives, for example, reported developing a plan for a CDO-like financial instrument at the Bank of America in 1997:

one of the salespeople in Bank of America was in our Chicago office, getting a cup of coffee, showing it [the planned instrument] to a colleague. The guy behind leans over and says, thats a really neat idea. Hes been doing that for years securitizing putting diversified pools of assets into a vehicle and tranching off the risk

The derivatives teams brought with them a crucial new tool and a different evaluation culture. The new tool was the credit default swap, an idea developed in the early 1990s at Bankers Trust, a bank that was characterized by its emphasis on viewing a financial instrument as a bucket of risks (as an interviewee involved put it), each component of which could be made into a tradeable instrument. Just as interest-rate swaps make the risk of interest rate movements tradeable, a credit default swap separates out the credit risk involved in lending and makes it into a tradeable instrument. It is a bilateral contract in which one party buys and the other sells protection against default by a third party (Ford Motor Company, for instance) on bonds issued by it and/or loans made to it. Should Ford default, the protection buyer has the right to deliver Fords bonds or loans to the protection seller, and receive their full face value. The protection buyer does not need to hold Fords bonds or loans; it can simply purchase them at the point at which they have to be delivered (following default they will be trading at a fraction of their face value). By the end of the 1990s, credit default swaps had become

28 largely a canonical-mechanism market. The main industry body, ISDA (the International Swaps and Derivatives Association), which was set up in 1985, had taken on the difficult and sometimes highly contentious minting work of standardizing their terms (interview data; see also Marshall 2003). With a dozen or more major banks acting as marketmakers, reasonably liquid markets trading credit default swaps on several hundred corporations came into being (Rule 2001, p. 124).

As the former Bank of America derivatives specialist put it to me, credit default swaps thus gave him and his colleagues a capacity the sarcastic coffee-queue interlocutors ABS culture did not have, for all its much longer experience of securitization: what he couldnt do was synthetically transfer credit risk. Swaps made possible synthetic CDOs. Instead of the CDO having to buy loans or bonds for its asset pool, as in other forms of securitization, it could simply sell protection on them via credit default swaps, using the premiums it received from the swaps to pay the investors in the CDO. Those investors faced a broadly similar pattern of risks and returns (again, for example, investors in the lowest tranche were first to lose their capital, in this case if one or more of the swaps were triggered by default on the bonds and/or loans they covered), but a synthetic CDO was quicker and easier to set up than a cash CDO, as a CDO that involved the actual purchase of loans and bonds came to be called.

The different evaluation culture that the derivatives specialists brought with them involved treating credit risk in a more mathematical way than it had been treated in the evaluation culture surrounding ABSs. (That latter culture was not in fact mathematically unsophisticated, as some derivatives specialists imagined it, but its most intensive

29 modeling efforts were focused on a different issue, prepayment.) The value of a CDO, whether cash or synthetic, depended on three characteristics of its asset pool: 1) 2) The probability of default on each asset; The recovery rate for each asset (that is, the extent to which the loss following default is less than total); 3) Credit correlation, in other words the extent to which defaults, if they happen, are likely to cluster. When considering how to model a CDO (especially the subtle and difficult issue of correlation), the derivatives specialists predominantly turned to a family of models that have become known as Gaussian copulas.31 Their original inspiration was the most famous derivatives model of them all, the Black-Scholes (or Black-Scholes-Merton) option pricing model, the developers of which had shown how it could also be used to model the default of a corporation on its debts (see Black and Scholes 1973 and, especially, Merton 1974).

31

A copula function (a formulation introduced to mathematical statistics by Sklar 1959) joins

together the univariate distribution functions of two or more random variables in such a way as to yield their bivariate or multivariate joint distribution function. (A Gaussian copula is a copula function corresponding to a bivariate or multivariate normal distribution.) Copula functions were brought to the study of credit risk by Li (1999 and 2000), who used them to specify the dependence amongst the survival or hazard-rate functions that model the time at which a corporation defaults. When referring to Gaussian copulas, I also include models such as CreditMetrics and the original 2001 version of CDO Evaluator (discussed below), which are single-period (all that is modeled is whether a corporation defaults during the period in question, not when), but in which what is in Lis terms the copula function is Gaussian.

30 Oldrich Vasicek, a Czech-born probability theorist who in 1968 was hired by Wells Fargo (for which Black and Scholes worked as consultants), then showed how the stochastic process postulated in the work of Black, Scholes, and Merton could be extended from modeling default by a single corporation to multiple corporations, the values of whose assets were correlated (Vasicek 1991). In a different formulation, involving computerized Monte Carlo simulation,32 the Gaussian copula was incorporated into CreditMetrics (Gupton, Finger, and Bhatia 1997), a system for measuring credit risk developed by J.P. Morgan and made available to other market participants because (as an interviewee involved told me) the bank, which was a particularly active proponent of credit default swaps, wanted to promote the market for them by giving other banks a way of measuring how they could use those swaps to reduce credit risk.

The phenomenon that the Gaussian copula attempts to capture the extent to which defaults are likely to cluster matters because holding everything else constant (i.e. with unchanging default probabilities and recovery rates for the assets in a CDOs pool), the extent of likely clustering dramatically influences the risks faced by investors in a CDOs different tranches. If likely clustering is low, then only the lowest tranche of a typical CDO is at substantial risk: defaults are unlikely to impact higher tranches. If likely clustering is high, however, then those higher tranches are at greater risk. A metaphor used by J.P. Morgans credit-derivatives specialists was:

32

Originally developed at the Los Alamos nuclear weapons laboratory, Monte Carlo simulation is

widely used to obtain numerical solutions to problems for which analytical solutions (i.e., solutions that take the form of explicitly specifiable mathematical functions) have not been found. Aside from in a special case identified by Vasicek (1991), Gaussian-copula models of CDOs do not have fully analytical solutions.

31 a cat walking blindfolded through a room filled with [a set number of] mousetraps. If the cat has only one life, he would prefer the traps to be located in clusters. The cat will lose his life whether he hits a single trap or a cluster. At least with the traps in clusters, there will be paths between them. The same is true of a lower-rated tranche of a CDO: the holder of such a tranche would prefer high correlation, or clustered traps.

If the cat is a more traditional cartoon cat, one with nine lives, he is happy for the traps to be scattered evenly round the room. He can afford to hit a few traps, but does not want to hit a large cluster which would wipe out all his nine lives. Likewise investors with senior tranches prefer low correlation (Watts 2004).

That defaults tend not be statistically independent events was of course known to ABS specialists, but they did not formulate this in an explicit notion of credit correlation.33 In contrast, correlation became a central concern of the derivativesinfluenced evaluation culture of those CDOs whose underlying assets were corporate loans or bonds. Using a Gaussian copula or similar model forced one to employ a specific value or set of values for credit correlation, and estimates of the risk of loss on a CDOs tranches, especially its senior tranches, are hugely sensitive to the estimate of correlation employed.34
33

See, for example, Fabozzi, Bhattacharya, and Berliner (2007), which analyzes mortgage-backed

securities without recourse to correlation.

34

See Heitfield (2009), who for instance shows, in a relatively realistic example, that estimating asset

correlation (assumed to be the same amongst all pairs of assets) to be 0.15 when the true value is 0.2 underestimates senior-tranche risk by more than 50 percent.

32

How to measure credit correlation was, however, far from straightforward. The interpretation of the concept closest to the work in financial economics that lay in the background of the Gaussian copula was the correlation of corporations net asset values. (Default can be conceived of as happening when a corporations net asset value falls below zero, in other words when its liabilities exceed its assets.) Net asset value, however, is not directly observable. Calculating it requires, in the words of one interviewee, working out how much it would cost you to become the sole owner of those assets, buying all the stock, buying all the paper [short-term debt], paying off the bonds, paying off bank loans, payables, all that. There will most likely be a canonicalmechanism market in the corporations stock, and possibly in its bonds, but other components of net asset value can be inferred only from balance sheets, which are published at best quarterly and often involve accounting conventions not helpful to the estimation of net asset value. One firm, San Francisco-based KMV (co-founded by Oldrich Vasicek), did seek to measure corporations fluctuating net asset values and from the resultant time series inferred the correlations between the values of different corporations, and it made these data available to subscribers. Many in the market, however, preferred simply to use the readily measurable correlation between corporations share prices as a proxy for their asset-value correlations. That, for example, was how J.P. Morgan and others obtained the correlation values used in CreditMetrics.

Initially, just as they did with mortgage-backed securities, the rating agencies evaluated CDO tranches using predominantly rule-of-thumb methods. For example, the effects of what from a Gaussian-copula perspective was correlation between different firms in the same industry was taken into account by S&P via notching: in the analysis

33 of a CDO, the rating of a corporate bond or loan in its asset pool would be reduced by one or more notches (that is, rating grades, e.g. reducing the rating from A+ to A, or from A- to BBB+) if the corporation came from an industry that formed more than 8 percent of the pool (Standard & Poors n.d., p. 36). Both S&P and Moodys captured inter-industry correlation via stress factors, which were multipliers applied to the default rates corresponding to the ratings of the assets in a CDOs pool when assessing whether a given tranche of the CDO qualified for a particular rating. A tranche with a AAA rating, for example, would have to be able to survive a very serious economic downturn and the clustering of defaults across industries it would bring, so a high stress factor was applied in that case, while lower stress factors were applied for lower ratings.

With the major banks having moved largely to explicit correlation models, especially Gaussian copulas, rule-of-thumb techniques such as notching began to seem outdated. Both S&P (in 2001) and Fitch (in 2003) switched to rating CDOs using Gaussian-copula models implemented via Monte Carlo simulation.35 S&P maintained continuity with earlier CDO rating methods by careful choice of the corporate correlation parameters in its new computerized system, CDO Evaluator, and by retaining stress factors. For corporate assets, for example, the parameters in the original 2001 version of Evaluator were 0.3 for the correlation between firms in the same industry and zero for firms in different industrial sectors (Bergman 2001). The latter was not an empirical
35

Moodys developed a distinctive approach to modeling CDOs involving calculating the CDOs

diversity score (Lucas 1989) and using it to map the CDOs asset pool onto a hypothetical pool of homogeneous assets whose defaults were independent events and to which, therefore, the binomial formula from elementary probability theory could be applied (Cifuentes and OConnor 1996). Moodys also moved from this binomial expansion technique towards Gaussian copula formulations, but more gradually: see note 45.

34 claim (though it was criticized as such: everyone said, how can you have no correlation between industries?), because of the retention of stress factors, which built in interindustry correlation implicitly. The intra-industry correlation of 0.3, similarly, was chosen, in an interviewees words, partly to maintain consistency with the previous notching scheme: when applied to similar asset pools it tended to generate similar results, i.e. similar ratings and credit enhancement levels. (Consistency and continuity matters to rating agencies, in part because existing rating methods have been tested empirically, in the sense that it is possible to check whether the subsequent performance of instruments rated using them is consistent with those ratings; and in part because a radical shift in criteria can be disruptive, especially if it implies downgrading previouslyrated instruments for reasons other than already-evident performance problems.36)

When S&P did move with version 3.0 of Evaluator, released in December 2005 to correlations based more immediately on statistical estimation, it used not share prices, as was common in the finance sector more generally, but the historical experience of defaults. (For all the cultural sway of the canonical mechanism, rating agencies are generally reluctant to employ market prices in any central role,37 because their aim is not usually to judge the immediate prospects of a corporation, ABS, or CDO, but its likely performance across an economic cycle, including conditions that may be quite different from those influencing current prices.) By 2005, S&P had something like 1,300 or so default events within its corporate-ratings database, and it inferred typical levels of

36

See, e.g., the criticism of Fitchs allegedly frequently changing correlation matrix reported in

Tavakoli (2005, p. 10).

37

The main exception is that when, in 2003, Fitch moved to its Vector Gaussian-copula system, it used

asset correlations derived from factor analysis of share prices (Gill et al. 2004, pp. 10 and 26).

35 asset-value correlation from the clustering of these defaults. Although, as the interviewee quoted here put it, the error bars [of the estimates of correlation] are not tiny, the estimates were thus based directly on the phenomenon at stake: default. Stress-factor multipliers were no longer needed. Inter-industry correlation was increased from zero to 0.05, and the correlation for two firms in the same industry (and same country) reduced from 0.3 to 0.15 (Gilkes, Jobst, and Watson 2005, p. 22).

It is important to note (because there is a sharp contrast here between the CDOs discussed in this section, whose asset pools were made up of corporate debt, and those discussed in the next section, whose asset pools were ABSs) that the rating agencies were far from alone in this focus on credit correlation. Crucial in enhancing attention to correlation was a new instrument, the single-tranche CDO. This was a bilateral contract between an external investor and a dealer (typically a credit-derivatives trading desk at a major bank), in which the investor earned regular fees by selling the dealer protection on a particular tranche of losses on a mutually-agreed pool of corporate bonds and/or loans. Introduced in around 2001, by 2003 single-tranche deals dominated the corporate CDO market (Reoch 2003, p. 8). They offered investors the freedom to choose the corporations on which they wanted to sell protection (thus avoiding the risk that a bank arranging a CDO to shift loans off its balance sheet would select the loans it privately knew to be riskier), and allowed dealers to concentrate on tranches popular with investors notably mezzanine tranches, which offered healthy spreads but also investment-grade ratings without having also to find investors for the less popular tranches. Because they were synthetic (the corporate loans or bonds in question served simply as a reference pool, a way of defining the deal; they didnt have to be bought), single-tranche CDOs were also quick and easy to set up. A traditional cash CDO takes a lot of time and

36 effort. Youve got to go and find a billion dollars of assets, find the investors that want to take all that risk from you, get it rated. The whole thing takes three months to do, said an interviewee. In contrast, single-tranche technology is all over in a week. You dream up the portfolio on a Monday, structure on the Wednesday, Thursday, and Friday.

Single-tranche CDOs were a spur to understanding and modeling correlation because unlike a CDO in which all tranches were sold to external investors (and the arranger of the CDO was thus left with no credit risk), a single-tranche CDO leaves a dealer with a position that needs hedged. (The dealer has bought protection, and thus the hedges will consist predominantly of sales of protection. Since these are incomegenerating, they earn the dealer the money to pay the investor and earn a profit from the deal.) This hedging was not a simple task, because the fluctuating value of a tranche reflects not just changes in the perceived individual creditworthiness of the corporations in the CDOs reference pool but also changing beliefs about the likely clustering of defaults.

The result was a wave of innovation in correlation modeling and a new set of canonical-mechanism markets.38 Gaussian copulas were supplemented by other copula functions, and Monte Carlo implementations were replaced by faster semi-analytical formulations. In 2003-4, the main credit-derivatives dealers set up markets in tradeable credit indices. Such an index resembles a standardized synthetic CDO in most cases with a fixed list of 125 corporations each making up 0.8 percent of its reference pool and protection can be bought or sold on either the index as a whole or on standard

38

These developments will be treated in a separate paper by the author on the biography of credit

correlation, so are summarized only briefly here.

37 tranches of it. The indices (which quickly became liquid, high-volume markets) helped dealers hedge their positions in single-tranche CDOs, and provided a new way of estimating credit correlation. A Gaussian copula or similar model could be applied backwards to infer the correlation levels consistent with the prices of protection on index tranches. (E.g. if the cost of protection on higher tranches has increased, but the cost of buying protection via credit default swaps on the individual corporations making up the index is unchanged, it can be inferred that participants estimates of correlation have increased.) If the model was correct, and if the index market had the claimed theoretical virtue of an efficient, canonical-mechanism market of reflecting all available information, then this should yield the best possible estimate of correlation.

Consensus on the Gaussian copula and on the extent to which the index markets were proper canonical-mechanism markets was never in fact strong enough for correlations derived in this way simply to be taken as real. However, they were regarded as real enough to persuade banks accountants and auditors often to treat creditderivatives deals as eligible for Day 1 P&L in other words for the entire estimated present value of the deal to be treated as immediate income to the bank and credited to the trader in the P&L (profit and loss) calculations on which bonuses were based even if the deal did not involve passing on all credit risk to external parties. This was important to the growth of the field, because setting up a credit-derivatives deal involves initial costs (such as legal fees) that can be greater than the first years profit. If all the trader is credited with initially is the latter, she will thus incur a loss that reduces her bonus in the year in question. Indeed, some interviewees asserted that the resultant need to find observable market values of correlation that would satisfy accounting standards was the main motivation for setting up the tranched credit-index market, although

38 probing the issue with those most directly involved in its establishment suggests it was an incidental benefit of what was intended initially as a way of helping dealers hedge their single-tranche CDO exposures.

The Boring Part of the Market: ABS CDOs

Alongside this world of corporate CDOs, with its increasingly sophisticated products and advanced models, another world of CDOs was however developing: CDOs in which the underlying assets were ABSs, residential mortgage-backed securities in particular. Viewed from the corporate CDO world, ABS CDOs could seem laggards: a very boring part of the market, as one interviewee put it, in which profit came only from originating transactions; it didnt come from risk-taking, it didnt come from like good credit assessment. It was purely, you know, in structuring fees. The International Swaps and Derivatives Association standardized the terms of credit default swaps on ABSs only in June and December 2005 (Damouni 2005), six years later than in the corporate world. The single-tranche CDOs that reshaped the corporate CDO world were relatively rare in the world of ABSs. A set of tradeable ABS indices (the ABX) was launched only in January 2006, and a tranched ABS index (TABX) only in February 2007. As innovations of this kind, originating in corporate CDOs, were replicated for ABS CDOs, the latter nevertheless would catch up, an interviewee told me in January 2007: the asset-backed arena is going to ape, I think, the corporate [The] ABS market will get there in half the time it took the corporate market. Before that could happen, however, ABS CDOs, that boring part of the market, were to be at the core of the greatest financial crisis for the best part of a century.

39

CDOs in which the underlying pool of debt instruments were tranches of ABSs, rather than corporate bonds or loans, date from July 1995,39 but their share of the CDO market remained small until 2001. No ABS CDO was issued in 1997, only two in 1998, and six in 1999 (Newman, Fabozzi, Lucas, and Goodman 2008, p. 34, exhibit 1). However, the 2000-2002 downturn led to defaults and bankruptcies (e.g. of overambitious telecoms providers) that caused sharp losses to investors in CDOs whose asset pools were made up primarily of speculative-grade corporate bonds issued at the end of the 1990s. In that context, the excellent performance record of ABSs made them seem an attractive substitute for corporate debt. In a single year, ABS CDO issuance more than doubled (to in excess of $20 billion in 2001) and the ABS share of the CDO market roughly tripled (Hu 2007), and issuance continued to grow sharply thereafter: in 2006 alone, ABS CDOs totaling $307.7 billion were issued.40 As noted above, some of the more recent categories of ABSs performed badly in 2001-2, and, as a result, the pools of ABS CDOs issued after that became increasingly dominated by the original category of ABSs, mortgage-backed securities. By 2004, it was common to find CDOs in which 75 to 100 percent of the pool consisted of these securities (Whetten and Adelson 2005, p. 2).

The underlying mortgage ABSs continued to perform well, even when (as was increasingly the case from the late 1990s onwards) the mortgages in question were no longer prime. The relatively modest credit-enhancement cushions required for

39

The first ABS CDO was the $510 million Pegasus One, Ltd., completed on July 1, 1995, which was

managed by Alliance Capital and underwritten by Paine Webber (information from interviewee).
40

Data from the Securities Industry and Financial Markets Association (http://www.sifma.org,

accessed July 21, 2009).

40 securitizations of prime mortgages were greatly increased for subprime mortgages: those in which the borrowers had poor credit histories and/or there were other indicators of risk, such as exceptionally high loan-to-value ratios or incomplete or absent documentation of matters such as borrowers incomes. This credit enhancement was provided not just by tranching but also by two other mechanisms that protected holders of mortgage-backed securities against loss: excess spread and overcollateralization.41 That these mechanisms could adequately protect ABS investors seemed to be confirmed when the delinquency rate on subprime mortgages doubled in six months in 2000 and remained high for the next two years (Sanders 2008, p. 256, chart 2). Although there were some ABS defaults (Erturk and Gillis 2005), they were concentrated mainly in a limited number of troubled deals, and left the majority of ABS investors unscathed.

- FIGURE 3 AROUND HERE -

The schematic structure of a typical subprime mortgage ABS is shown in figure 3. The rating of ABSs was no longer done using the rule-of-thumb assessments of mortgage pools sketched in this papers third section. All three of the main agencies developed systems S&Ps Levels, Moodys Mortgage Metrics, and Fitchs Resilogic that incorporated multifactorial regression or hazard-rate models of the default probabilities of individual mortgage loans. The factors or independent variables employed included
41

Excess spread is the difference between the aggregate interest payments received from mortgagors,

net of fees, and the interest payments to investors; it can be employed to build up what are in essence reserves. Overcollateralization means that the total principal sum of the mortgages in the pool is greater than that of the securities held by investors, either because the deal was structured that way initially or because of turboing, the use of excess spread to repay some investors and thus reduce the amount of securities still outstanding (Fabozzi, Bhattarcharya, and Berliner 2007, pp. 102 and 188).

41 borrowers FICO scores (Fair Isaac Corporation credit scores), loan-to-value ratios, extent of documentation, etc., and the parameters of the models were estimated using the extensive loan-level mortgage data sets that had become available.42 In the rating agencies systems, these default probability models were combined with multifactorial recovery-rate models (and in the case of two of the agencies, with Monte Carlo simulation of a range of macroeconomic conditions) to generate a probability distribution of overall losses on the pool of mortgages underpinning the security being rated (SEC 2008, pp. 33-34).

-FIGURE 4 AROUND HERE -

Tranches of subprime mortgage-backed securities were packaged into ABS CDOs in two main ways: see figure 4. If the higher tranches were used, the result was what was known as a high-grade ABS CDO. Its higher tranches could be portrayed to investors as ultra-safe, because there was a second cushion (the lower tranches of the ABS CDO as well as those of the underlying ABSs) protecting them from default on the underlying mortgages (Ishikawa 2009, pp. 210 and 219). Increasingly, though, the mezzanine tranches of ABSs were used instead. From the viewpoint of the arrangers of the CDO, this was particularly attractive, since it was an efficient use of tranches of mortgagebacked securities that were sometimes hard to sell directly to investors.

An ABS CDO was a Russian doll (Lucas 2007): it was a tranched, packaged instrument, each component of which was itself a tranche of a packaged instrument.

42

FICO was a crucial market device, enabling the prediction of default to move downwards from pools

of mortgages to individual loans: see Poon (2007, 2009) and Rona-Tas (2009).

42 How might the value of these Russian dolls be determined? Again, no canonicalmechanism market in them existed (nor, at least until the introduction of the ABX in 2006, was there one in the underlying mortgage-backed securities), so modeling and rating were again crucial. An ABS CDO was a hybrid. Although its components (chiefly mortgage-backed securities) and their packaging (the CDO) were structurally very similar, the evaluation cultures that surrounded them were, as we have seen, quite different. There were therefore two paths by which knowledge of the value of mortgagebacked CDOs could have been developed: an ABS CDO could be thought of as a hypercomplex ABS, a very complicated set of claims on a large set of pools of mortgages; or it could be thought of as just another variety of CDO.

ABS CDOs were generally arranged by banks structuring or securitization departments, who were ABS specialists, often with few links to the derivatives departments that had usually handled credit default swaps, synthetic corporate CDOs, tradeable indices, etc. (A senior derivatives quant in one investment bank told me he was completely unknown to most members of its structuring department: the two areas of the bank really have very few points of intersection.) Unsurprisingly, therefore, ABS specialists seem to have followed the first path. Their main tool was a system called Intex, a computerized deal library that seeks to capture the often complex cashflow rules of over 20,000 ABSs and CDOs.43 Intex is a remarkable achievement, rendering the cashflow consequences of somewhere between 4 million and 10 million pages of legal documents into computer form. (The documentation of each ABS or CDO is typically between 200 and 500 pages.) Without Intex, the complexity of the interconnected world of ABS CDOs would have been cognitively unmanageable.
43

http://www.intex.com, accessed September 3, 2009.

43

Intex did thus model an ABS CDO as a complicated set of claims on a set of pools of mortgages, and its users could employ it to produce a valuation of an ABS CDO by choosing a scenario (a set of assumptions about mortgage default and recovery rates, and prepayment speeds) to input into the Intex model of each of the underlying ABSs, and then running the output of each of those models through Intexs model of the cashflow rules of the ABS CDO. However, the asset pools of many ABS CDOs included not just ABSs but also tranches of other ABS CDOs, greatly complicating matters.44 Unless the network of connections was pruned quite radically in the analysis, the computer time needed to run even a single scenario could be very lengthy: interviewee 1: hours and hours and hours interviewee 2: Days I would interviewee 1: and come up with a single number that this thing [ABS CDO tranche] is worth under that single scenario Furthermore, the result would hold only temporarily. The manager of a CDO usually has the right to change the composition of its pool within defined ratings guidelines by buying and selling assets (in this case ABSs or tranches of ABS CDOs), so the operation would have to be repeated every time this was done. Accordingly, it seems to have been common for market practitioners to produce only a small number of Intex valuations of any given ABS CDOs: for example, one under the scenario judged most likely, plus some stressed scenarios with adverse default rates, etc.

44

Two interviewees reported that it was not unknown for one ABS CDO to buy a tranche of a second

ABS CDO, which had in its turn bought a tranche of the first CDO. Each of the two CDOs was thus itself indirectly a component of its own pool of underlying assets.

44 Such an approach might generate a plausible enough valuation of an ABS CDO, but did not produce what the ratings agencies needed: an assessment of the credit risk of its tranches. In practice, therefore, the rating agencies had little option but to follow the second path, and to analyze ABS CDOs in a similar way to corporate CDOs. That had the advantage that there was then no need directly to tackle the structural complexities of the tranches of ABSs or of ABS CDOs that made up the asset pool of an ABS CDO. Those tranches could be treated simply as analogous to corporate bonds, and at least at Standard & Poors and Fitch the Gaussian-copula models built into S&Ps CDO Evaluator and Fitchs Vector could be employed.45 As far as I can tell, to the extent that the analysts in the different offices of the rating agencies were divided into a mortgage or ABS section and a derivatives or CDO section which was not always the case responsibility for ABS CDOs was given to the CDO specialists.

The default probabilities for each of the ABS or ABS CDO tranches that made up the CDOs pool were estimated from its rating, with some correction made for the growing evidence that ABS tranches typically had lower default rates than corporate bonds with the same rating. Rates of recovery (also generally superior to those of corporate bonds) were estimated by examining what happened following the relatively limited number of ABS defaults (Erturk and Gillis 2005; Tung, Hu, and Cantor 2006).
45

Although Moodys also analyzed ABS CDOs as another variant of a CDO, it did modify its approach

somewhat. As ABS CDOs highly concentrated in a single asset class (residential mortgages) became more popular, Moodys concluded that its traditional technique for analyzing CDOs the binomial expansion outlined in note 35 was no longer adequate, and in 2005 shifted to the correlated binomial (Witt 2004; on the shift, see Creditflux 2005), which as the name suggests included explicit modeling of correlation. Its output at least in the examples in Witt (2004) seems to have closely resembled that of a Gaussian copula.

45 Again, though, correlation posed the rating agencies the most challenging problems. (Recall that the correlation estimate is crucial, especially in calculating the risk to a CDOs higher tranches.) All three of the routes discussed in the previous section by which knowledge of corporate credit correlation was generated were largely blocked when it came to ABS correlation. First, there was no full equivalent of corporations share prices to use, because ABSs did not trade in a canonical-mechanism market. Second, the very advantage of ABSs the rarity of ABS defaults made extracting a reliable correlation estimate by analysis of the clustering of defaults even harder than in the corporate case.46 Third, until the introduction of the TABX in February 2007 there was no tranched ABS index market that could be used to infer correlation.

That left essentially two choices: either estimating correlations from the performance record of ABSs as crystallized in an agencys own previous actions in upgrading or downgrading ABS tranches (these ratings transitions are more plentiful than defaults, thus easing the estimation problem), or directly employing human judgement. For example, Fitchs correlation estimates were based explicitly on expert assumptions (Zelter 2003, slide 5; see also Gill et al. 2004, p. 10), while Moodys used baseline estimates based on ratings transitions, with judgemental additions (Toutain et al., 2005). Only in the case of S&P (see below) have I more-or-less full information on the exact

46

Thus an interviewee told me in an email message, We did try to estimate ABS correlations, but the

data was too limited to derive reliable/stable estimates, given the relative stability of ratings, paucity of defaults and the number of different asset classes with different dynamics resulting from different transaction structures and underlying assets. (For example, homogeneous credit card deals exhibited very different behavior to more heterogeneous commercial MBS deals).

46 numerical values used over an extended period of time.47 What is clear, however, is the outcome: the correlation values employed by the rating agencies (though generally higher than the equivalent estimates employed in the analysis of corporate CDOs) were modest enough to make possible ABS CDOs of the kind shown in the right-hand side of figure 4, with substantial AAA tranches even when the underlying ABSs had BBB ratings.48
47

With Gaussian-copula or similar models being used, and with the asset pools of ABS CDOs

increasingly concentrated in US subprime-mortgage ABSs, the crucial correlation parameter was the assumed level of asset correlation within that sector, where I have figures for all three main agencies from 2005 (but, unfortunately, only from then). Moodys baseline correlation was 0.22. That would be increased according to the closeness of the vintage (year of issuance) of the ABSs (e.g. by 0.1 for the commonly encountered case of pairs of mortgage ABSs of the same vintage). There was also a key agent penalty, which added 0.2 to the correlation of those pairs of ABSs where the same company serviced the underlying mortgages (Toutain et al. 2005). In S&Ps case, the assumed correlation was 0.3 (see below), with to my knowledge no equivalent mandatory add-ons (S&Ps analysts had the discretion to increase correlation estimates for CDOs with particularly highly concentrated asset pools, but the circumstances under which this discretion was used are unclear). Fitch employed a range of correlations from 0.3 to 0.55, but unfortunately my source (Whetten and Adelson 2005, p. 2) gives no indication of the factors that determined choice within this range.
48

If this seems counterintuitive, consider the analogy of selling fire insurance (for a seven-year period,

say) on a hypothetical village of 100-150 houses (the typical number of assets in the pool of an ABS CDO). The inhabitants of the village are somewhat careless with matches, so there is a BBB-like probability of around one in fifty (see table 1 below) that any given house will burn down during the duration of the insurance policy, but the houses are fairly widely spread out, meaning that fires are statistically more-or-less independent events, and correlation is thus low. A policy that has to pay out only if a quarter or more of the houses burn down during the seven years is a pretty safe, AAA-like, bet from the insurance companys viewpoint: it would expect around two or three homes to burn down, and while more certainly could, only with very bad luck will a quarter or more do so. (The senior AAA tranche of a typical mezzanine ABS CDO figure 4, lower right with the four tranches below it totaling around 24 percent and with excess spread see note 41 providing a further cushion against

47

Nor were the rating agencies alone in this evaluation. Crucially because this became one of the two main ways in which the problems of ABS CDOs sparked the global banking crisis the AAA tranches of ABS CDOs were normally divided into two, as depicted in the right-hand side of figure 4. The lower tranche was sold to outside investors, but the higher tranche, often called super-senior (which was usually larger than all the other tranches put together, sometimes by a considerable margin: see figure 4) was usually retained by the bank that arranged the CDO. This practice began in the world of corporate-loan CDOs, with J.P. Morgans December 2007 Bistro (Broad Index Secured Trust Offering: see Tett 2009a). The problem, in essence, is that there is a finite cash flow into a CDO from the assets in its pool, which needs to be divided up in such a way that the lower tranches offer enticing spreads (increments over Libor). This means that the super-senior tranche can offer only a very modest spread, insufficient to make this tranche attractive to most outside investors.

The credit risk involved in a bank retaining the super-senior tranche of a CDO it was arranging was often dealt with by it buying protection on the tranche via a credit default swap with a monoline (a specialist bond insurer) or the Financial Products Division of the giant US insurer AIG. The swap premiums the monolines and AIG demanded in return for taking on this credit risk were small, indicating that, as with the rating agencies, their evaluation was that the risk involved in a typical super-senior tranche was very low. As an interviewee put it, Monolines will write

default, is roughly analogous to that insurance policy.) Of course, if correlation is high, then things are very different. If it approaches 1.0 (in which case if one house burns down, they all do), then a policy that has to pay out if a quarter or more burn down is very far from a safe bet.

48 that [sell protection on super-senior tranches of ABS CDOs] all day long at 12 basis points, in other words for an annual premium of only 0.12 percent. (It again seems as if the assessment of ABS CDOs at the monolines was done not by their mortgage departments but by their CDO departments: see Adelson and Jacob 2008a.)

These modest premiums made possible an activity without which the growth of the ABS CDO market would have been greatly constrained: the negative basis trade. In this, a trader retained the super-senior tranche of an ABS CDO (or even bought one from another bank) and bought protection on it from AIG or a monoline. Even though the spread on a super-senior tranche was very slender, it was normally a little larger than the cost of that protection, enabling the trader to make a small but apparently entirely riskfree profit. (In the credit derivatives market, the basis is the difference between the cost of buying protection on an asset such as a CDO tranche and the spread that the asset offers; here the basis is negative, hence the trades name.) Because the swap seemed to eliminate whatever modest credit risk was involved in the super-senior tranche of a CDO, it enabled that tranche to be classed in banks risk management and accounting systems as fully hedged, which in turn allowed the full net present value of the income stream from it (minus the swap premiums and the estimated costs of funding the position) to be booked immediately as profit: as Day 1 P&L. The negative basis trade was thus very attractive. UBSs traders, for example, bought super-senior tranches totalling $20.8 billion, $15 billion of them for negative basis positions, and the latter were all judged Day 1 P&L eligible by the banks relevant division, Business Unit Control (UBS AG 2008, pp. 14-15 and 23). Some traders may privately have doubted whether, in the cataclysmic scenario in which widespread losses were incurred even on super-senior tranches, the monolines or even AIG would have the financial strength to pay out, but

49 that scenario seemed vanishingly unlikely. In order to secure Day 1 P&L, people bought protection they knew was worthless but that they know they will never need, as a risk manager at another bank told me in an email message on April 8, 2008 (at which time the extent to which they actually did need that protection was only gradually becoming clear).

Traders capacity to buy protection on the super-senior tranches of ABS CDOs from AIG or the monolines had a wider consequence for the evaluation culture surrounding those CDOs. It meant that all their tranches could readily be sold or insured, and all the credit risk at least apparently passed from CDO managers to investors and insurers. In consequence, as one of those managers told me when I asked him how his firm had modeled correlation, there was no need for a correlation model. The modeling of the credit risk of ABS CDOs was implicitly delegated, by most other market participants, to the rating agencies, AIG, and the monolines. There was no equivalent of the widespread, rich, and lively culture of correlation modeling (and empirical testing of correlation models) surrounding corporate CDOs. The crucial incentive for that culture, the single-tranche CDO, did not form an important enough part of the ABS CDO market, and the tranched ABS index (TABX) came too late only in February 2007 to form an equivalent incentive. While there were around a dozen textbooks of corporate CDO correlation modeling, and hundreds of research papers stretching back over a decade, there was no textbook of ABS CDO correlation modeling, and I have been able to find only three publicly-available research papers, all recent (2007-8) and by the same two researchers from the Franco-Belgian bank, Dexia.49

49

See, e.g., Garcia and Goosens (2008).

50 There were, of course, growing doubts, especially from 2005 onwards, about the prospects for Americas housing market,50 doubts that had the potential to threaten the favorable evaluations of ABS CDOs. Their arrangers, however, were able to absorb dissent quite literally by using it to make possible further expansion of ABS CDOs. So attractive to investors was the combination of ratings and spreads offered by ABS CDOs that the construction of those CDOs helped create what was in effect a demand for more securitized subprime mortgages than actually existed, even with rising house prices and the ever-laxer lending that characterized the later years of the US housing bubble. Especially after the International Swaps and Derivatives Association published standardized legal documentation for ABS credit default swaps in June and December 2005, these swaps were used to manufacture additional subprime mortgage risk, as cash ABS CDOs (which actually bought ABSs) were joined by synthetic ABS CDOs (which didnt buy ABSs, but sold protection on them via swaps).51 The sales of protection needed to create a synthetic ABS CDO required investors prepared to pay for protection on subprime ABSs, and at least some dissenters mainly in hedge funds (Adelson, Whetten, and Bartlett 2005, p. 24) were willing to do just that, buying protection on the mezzanine tranches of ABSs in the expectation of them defaulting. (Recall that the protection buyer does not need to hold the asset in question, but can simply buy it cheaply after it has defaulted, deliver it to the protection seller, and receive its full face value.)

50 51

See, e.g., Adelsons ABS conference reports, referred to in the introduction. This may explain at least part of the apparently strange finding of Mason and Rosner (2007, p. 72)

that the CDO market purchased more mezzanine RMBS [residential mortgage-backed securities] in 2005 as [sic] was actually issued that year.

51

ABS CDOs and the Causes of the Credit Crisis

The overall performance of ABS CDOs is most easily tracked via the incidence of events of default, which are triggered by very poor performance of the underlying assets.52 While the ABS CDOs issued from 2001 to 2003 have not performed catastrophically by that metric, from 2004 on each successive vintage was worse than its predecessor. Events of default have been declared in around 30 percent of ABS CDOs issued in 2005; in over 40 percent of those issued in the first half of 2006; in over 70 percent of deals from the second half of 2006; and in over 80 percent of such deals as could be issued in 2007 (Sakoui 2009). The ABS CDOs involved number in the hundreds, indicating that random bad luck is unlikely to be the cause,53 and, as noted in the introduction, ABS CDOs are the single largest category amongst the losses that triggered the credit crisis.
52

Though there are a number of event-of-default tests laid down in the documentation of most CDOs,

the critical issue is whether ratings downgrades or other reductions of the value of the CDOs asset pool have been big enough to cause the pools total value to fall below the aggregate face value of the securities making up the CDOs topmost tranches (those initially rated AAA). That typically constitutes an event of default, following which control of the CDO passes from its managers to the controlling class of investors (normally the holders of the super-senior tranche), who have the right to declare an acceleration (which usually means diverting all cashflow to themselves) or to wind up the CDO by selling the assets in the pool (Goodman, Newman, Lucas, and Fabozzi 2007). Either course of action will leave the holders of lower tranches facing losses that may be close to total, and even the holders of the super-senior tranche will in current circumstances incur substantial losses.
53

A CDO event-of-default list is maintained at http://www.totalsecuritization.com. On September 17,

2009, it contained 394 CDOs totalling $356.7 billion. Although the collateral type cannot always be determined, a large majority are ABS CDOs.

52

The disastrous performance of recently-issued ABS CDOs has been caused by levels of default on mortgage-backed securities that are without precedent in the modern history of securitization, which in their turn have resulted from millions of American homeowners having stopped making (or never having made) payments on their mortgages. By spring 2009, 21 percent of the roughly 24 million private-label securitized US mortgages in Bloombergs database prime, subprime, and in the intermediate altA category were delinquent (60 days or more behind on payments). The overall subprime mortgage delinquency rate had reached 33.9 percent, and in some ABSs it was approaching 50 percent (May 2009; Eckblad 2009). With very poor recovery rates following foreclosures, these delinquency rates have meant that around half the BBB mezzanine tranches of subprime ABSs issued in 2005-7 have defaulted, and many of the higher tranches of those securities have also been hit (see table 2 below). These ABS defaults have fed through into ABS CDOs, and even the super-senior tranches of those ABS CDOs that are composed primarily of mezzanine ABSs face severe losses.

Explanations of a chain of disaster that has hit even instruments with AAA ratings have often focused on the organizations that produced those ratings: an example is Smith (2008a, b), who argues that competition between rating agencies fueled a race to bottom. Let me first outline the rationale for an analysis of this kind, before assessing it briefly and turning to other causes of the credit crisis.

Originally, rating agencies recovered the (then modest) expenses involved in producing ratings by selling publications containing those ratings. From 1968-70 onwards, however, the agencies started charging the issuers of securities fees for rating

53 them, and such fees became the agencies core source of income. (Prominent defaults notably the 1970 failure of the railroad company Penn Central, then the USs largest-ever bankruptcy seem to have made possible this shift in business model, because they increased the value to companies, and also municipalities, of authoritative external assessment of their creditworthiness.)54 When issuers pay raters for their ratings, and there is more than one rater, both issuers and raters face incentives that conflict in a complex way: awarding higher ratings than other raters do can increase a raters market share (i.e., the proportion of issuers who choose to employ the rater), but only up to a point at which this effect is outweighed by the way in which damage to the raters public reputation reduces the value of its ratings.

What matters, furthermore, is not simply the number of raters (as in the comparison between law school and business school ratings in Sauder and Espeland 2006) but the minimum number of ratings of each security that investors typically demand, which in both the markets for conventional corporate bonds and for ABSs and CDOs seems generally to have been two. Outside of limited niches, Moodys and S&P have long been the two dominant raters in the US market for conventional bonds (see, e.g., Flight 2001, pp. 7-8). With in effect two raters, and investors expecting two ratings, for one of the raters to offer higher ratings than the other would bring no advantage.

In the ABS and CDO markets discussed in this article, however, three agencies (Moodys, S&P, and Fitch) have been prominent since the early 1990s. This structural difference was potentially reinforced by a further change. There are hundreds of large54

See Cantor and Packer (1994, p. 4).

54 scale issuers of corporate bonds, making the loss of the business of any one of them a matter of no great consequence. There were, however, many fewer substantial issuers of ABSs and CDOs, each one of which was therefore a potentially important source of repeat business. The SEC examined 650 RMBSs (residential mortgage-backed securities) and 375 ABS CDOs issued in 2006-7:

While 22 different arrangers underwrote subprime RMBS deals, 12 arrangers accounted for 80% of the deals Similarly, for 368 CDOs of RMBS deals, although 26 different arrangers underwrote the CDOs, 11 arrangers accounted for 92% of the deals and 80% of the dollar volume. In addition, 12 of the largest 13 RMBS underwriters were also the 12 largest CDO underwriters, further concentrating the underwriting function, as well as the sources of the rating agencies revenue stream (Securities and Exchange Commission 2008, p. 32).

All three main rating agencies made the suites of software employed in rating mortgage-backed securities and CDOs available for downloading by those arranging them. Although ratings depended on more than the output of these systems,55 it seems to have been possible for arrangers to anticipate likely ratings reasonably accurately: You dont go for a rating unless you know what rating youre going to get, one CDO arranger told me in June 2006. The availability of these systems to the arrangers of ABSs and CDOs and the fact that the earlier rule-of-thumb methods often also had reasonably

55

Ultimately, all ratings are the responsibility of committees, including experienced members of a

rating agencys staff, who review not just the output of models but also other information (for example, the track record of the manager of a CDO or issuer of an ABS).

55 predictable outputs meant that their arrangers could work out how to structure them in such a way that their tranches had combinations of ratings and spreads that would be attractive to investors (see, e.g., Benmelech and Duglosz 2009).

That there were three rating agencies in a market that typically demanded a minimum of only two ratings, that their ratings processes were transparent and reasonably predictable, and that (though the ratings awarded by different agencies to the same instrument are usually similar) there were some salient differences between those processes, meant that arrangers could engage in ratings shopping. They could choose to be rated by the agencies that would give the more favorable ratings, and were sometimes quite open about doing so, for example approaching more than two agencies for ratings but choosing to use only the more favorable evaluations, paying at most only a break-up fee to the agency that was not used (Adelson 2007b, p. 10; Technical Committee of the International Organization of Securities Commissions 2008, p. 7). The process could lead to large shifts in market share. For instance, when Fitch started to rate mortgage-backed securities in 1990 it reportedly used as its most severe test not the default rates of the Great Depression (employed, as noted above, by S&P) but those of Texas during its serious, but less cataclysmic, 1980s recession. S&P rapidly lost market share, and by 1994 Fitch was rating almost 80 percent of deals by dollar volume (Cantor and Packer 1994, pp. 20-21 and chart 10). To take another example, when in April 2007 Moodys introduced new criteria that meant it demanded higher credit enhancement levels for securities backed by commercial mortgages, it reported that its market share fell from around 75 percent to 25 percent (Dunham 2007).

56 That ratings shopping was an ever-present possibility does not, however, imply that the rating agencies accommodated to it by slackening their criteria. Consider the changes in the parameters in S&Ps CDO Evaluator during the years in which ABS CDOs boomed, 2002-6. (I focus on S&P purely because commendably it made Evaluators default probability and correlation assumptions, both corporate and ABS, fully explicit in the publicly-available documentation of successive versions of the system.) The ABS correlation assumptions chosen when Evaluator was introduced in November 2001 (an intra-sectoral correlation of 0.3 and an inter-sectoral correlation of 0.1) remained unchanged.56 The ABS recovery-rate assumptions, held in a matrix separate from the main Evaluator model (Standard & Poors 2002, p. 68, table 3), similarly seem not to have changed in any substantial way. The default probability assumptions did change, but in no wholly consistent overall direction: see table 1. So there is no evidence of any systematic shift to estimates that favored the construction of ABS CDOs. The most plausible interpretation of the changing default probability assumptions is simply the attempt to provide more refined figures than the initial roughand-ready estimates (note that the 2001 estimates form an almost perfect geometric

56

Bergman (2001); Gilkes, Jobst, and Watson (2005). The only change that can be identified in

respect to ABS correlation levels is indirect. In version 3.0 of Evaluator (released in December 2005) inter-industry correlation was modeled explicitly (by a 0.05 correlation), while previously it had been captured implicitly by stress factors, which were therefore dropped. Since those factors would previously have had an implicit effect similar to using ABS correlations somewhat higher than 0.3 and 0.1, their elimination removed that effect. Note, however, that in version 3.0 the intra-industry corporate correlation was reduced (following estimation from default clustering) from its original value of 0.3 to 0.15, so the relative effect of these changes was to make the assumed level of ABS correlation considerably higher than corporate correlation.

57 series).57 Of course, that does not demonstrate that accommodation to actual or potential ratings shopping did not occur at other agencies, or in other aspects of S&Ps rating process, but it is surely of interest that it cannot be detected in the parameters of Evaluator, a system used to rate nearly all CDOs.58

- TABLES 1 and 2 AROUND HERE -

Although data limitations mean there is no way to be entirely certain,59 any accommodation by rating agencies to rating shopping is most unlikely to have been of sufficient magnitude to explain the catastrophic performance of recent ABS CDOs and the dramatic change in the default behavior of mortgage ABSs. In most rating categories,

57

The original version of Evaluator assumed a constant default probability, independent of the time for

which an ABS tranche was held: The thinking was that the rating process for the underlying deals smoothed out the time-dependency of default probabilities. In version 3.0 of Evaluator the decision was made to replace this with a term structure (i.e. time-dependent probabilities of default), but once again the historical data was too limited to do this directly, so instead we simply applied a scaling factor to corporate default rates. The scaling factors were chosen to provide the best overall agreement with the (limited) historical data, such as the average transition behavior of ABS and corporate ratings (email from interviewee, August 1, 2009).
58

S&P rated around 85 percent of CDOs (corporate and ABS) issued before 2004, and well over 90

percent of those issued in 2005-7 (Barnett-Hart 2009, p. 18, figure 8).

59

A sample of nine current or former rating-agency staff members is far too small (and also too

idiosyncratic in its selection) for reliable interview-based conclusions, and in any case not all ratingagency interviewees were comfortable discussing ratings shopping. The two who discussed the issue most directly (who coincidentally had both worked in the same office of the same agency, for overlapping periods) disagreed, one emphasizing pressures to maintain or increase market share, the other saying he had not experienced accommodations to ratings shopping.

58 the recent incidence of subprime ABS defaults (column 2 of table 2) has been over a hundred times the historical experience of ABSs as captured in CDO Evaluators assumptions. None of the specific allegations made in the literature critical of the agencies, such as Smith (2008a, b), seem even if verified to be of anything like this size in their likely effects.

The crucial issue, therefore, is not that models or other aspects of the ratings process changed but that the world did; and that it changed, in part (as I shall argue) because of the use of the models, in ways that reduced the empirical validity of the models. Two linked counterperformative processes set in. The first was that the rapidly growing popularity of ABS CDOs caused a structural change in the market for the underlying mortgage-backed securities. As noted above, most investors in the latter, who bought the large senior tranches, never worried much about credit risk. There was, however, a smaller but crucial stratum of investors who bought the mezzanine tranches, and they did often do their own credit analysis rather than simply relying on ratings (Fabozzi, Bhattacharya, and Berliner 2007, p. 20).

By 2005-6, however, those investors, and the specialists who earlier had insured the mezzanine tranches, had been displaced. About 90% of the recently issued triple-Brated tranches [of subprime ABSs] have been purchased by CDOs (Adelson 2006c, p. 5). The arrangers of those CDOs had no equivalent incentive to perform detailed credit analyses for example, by asking for the loan tape, the computer file in which the data on each mortgage and each borrower in an ABSs pool are recorded, and assessing it in the light of an understanding of the on-the-ground realities of subprime mortgage lending because the riskiness of ABS tranches would be represented in an ABS CDO model

59 only by their ratings. (In practice, too, even two or three days devoted to analysis would have meant that the ABS could no longer be bought: such was the demand for ABSs that their tranches sold almost as soon as they became available.) The arrangers of ABS CDOs were therefore often indiscriminate buyers, as one interviewee put it, purchasing tranches of mortgage-backed securities even when the ABS specialists amongst them knew they were getting riskier. So, you know, you talk to people [CDO arrangers], and theyre complaining about the quality [of ABSs] But they got a mandate to do the CDO, they got to get it done. They got to buy something. So, cos they want their fees.

All securitized lending generates a potential agency problem, if it involves the originators of loans being remunerated, directly or indirectly, according to the volumes they originate, while the credit risk is passed to external investors or insurers. (One of the predecessors of modern securitization was in the 1880s US, when a number of companies issued bonds backed by farm mortgages. The 1890s depression saw most such companies fail, in part because their local agents [g]enerally working on a commission basis were overgenerous in approving loans: Bogue 1955, p. 267.) What therefore needs explained in regard to mortgage securitization in the US is not that this agency problem manifested itself increasingly (and eventually disastrously), especially from 2005 onwards, but that it had been held in check for so long before that. Amongst the restraints was that those who insured or bought the mezzanine tranches of mortgagebacked securities were experts in mortgage credit risk and that expertise was reflected in their risk appetite and pricing behavior. By limiting the acceptable risks of the lower tranches, they limited the overall riskiness of mortgage-backed securities, and thus constrained subprime lenders from making unreasonably risky loans (Adelson and

60 Jacob 2008a, p. 1). Their displacement by ABS CDOs turned a potential agency problem into an actual one.

Hence the counterperformative process of which the numbers in table 2 are the trace. As noted, the models used to rate ABS CDOs assumed default probabilities consistent with the excellent previous record of ABSs, but the ABSs issued in 2005-7 have experienced enormously higher default rates. The growth of the ABS CDO (an instrument that was model-driven, in the sense that, as a CDO manager put it to me, the CDO market was all about ratings) led to a change in the composition of the market for mortgage-backed securities that helped invalidate the very models that made ABS CDOs attractive.

In that sense, the modeling of ABS CDOs changed ABSs. The second, linked counterperformative process is that the modeling of mortgages (in order to rate ABSs) changed mortgages, again in a way that rendered the models much less accurate. This is strongly suggested by three papers, using quite different methodologies, that have found evidence that the securitization of mortgages weakened the screening of applicants by the originators of those mortgages.60 Most relevant to the argument here is Rajan, Seru, and Vig (2008), who demonstrate that the role played in lenders risk assessment of applicants by two variables prominent in rating-agency and other models of mortgage default FICO score and loan-to-value (LTV) ratio greatly increased from 1997 to 2006.61 If a loan was going to be securitized, soft information information that

60 61

Keys, Mukherjee, Seru, and Vig (2008); Mian and Sufi (2008); Rajan, Seru, and Vig (2008). In 1997, FICO and LTV explained only 3 percent of the variance in mortgage interest rates in

securitized subprime mortgages; by 2006, they explained 50 percent (Rajan, Seru, and Vig 2008, table

61 cannot be directly verified by anyone other than the agent who produces it (Stein 2002, p. 1892), including subjective matters such as, as one interviewee put it: Do these people really look like theyll repay the loan? Do they look like they can afford this house? was of less direct value than apparently hard, independently verifiable information such as FICO and LTV, because it did not influence rating-agency models of mortgage-backed securities.62

The increasing influence on lending decisions of the hard information that formed the input to default models was accompanied, however, by sharp declines in the accuracy of those models as predictors of default. Rajan, Seru, and Vig (2008) construct a logistic regression model similar to rating-agency models of mortgage default (their model incorporates FICO, LTV, and documentation level, plus several characteristics of the mortgage itself), and estimate its coefficients using data from mortgages issued between 1997 to 2000, when fewer than a half of US subprime loans were securitized. They then show that the predictive power of the model consistently declines for mortgages issued in each successive year from 2001 to 2006. (By 2006, the default rate was over four times the models prediction.)

Two further processes turned losses on mortgages, ABSs, and ABS CDOs into a banking crisis by concentrating much of those losses at the apex of the global banking system. One, discussed in the previous section, was the way many leading banks retained
II). Since loans known to be riskier are generally made at higher interest rates, the latter are a proxy for risk assessments.
62

Of course, soft information had in the past often been inferred from skin color. Racial

discrimination, and ways of trying to eliminate it, were important issues in policy debate in the US in respect to mortgage lending (see, e.g., Rona-Tas 2009).

62 or bought the super-senior tranches of ABS CDOs. The other is that a cash ABS CDO typically took several months to construct, and ABSs had to be held (warehoused, as participants put it) while construction was underway. Faced with a sometimes frustrating sellers market on both levels (the acquisition of ABSs for CDOs, and the acquisition of mortgages to securitize into ABSs),63 several banks acquired subprime lenders or moved directly into subprime lending, so creating a largely in-house ABS CDO assembly line, in which mortgages were originated, packaged into ABSs, and then the ABSs packaged into CDOs. After the crisis hit in the early summer of 2007, ABS CDOs could no longer be sold, so the banks that had assembly lines and warehouses and had not been able fully to hedge their contents were exposed to large losses from the mortgages and ABSs they contained.64

Losses, however, are not self-evident things: they need to be rendered visible. A crucial role in this respect was played by the new canonical-mechanism tradeable indices referred to above, the ABX, which were launched in January 2006.65 They enabled
63

Demand for mortgages to turn into ABSs was so strong that mortgage brokers found themselves

subject to eager attention from wholesalers, representatives of banks or other finance companies who would pay commissions to brokers for their clients mortgage applications. Some wholesalers reportedly offered sexual favors in addition to fees (der Hovanesian 2008).
64

See, e.g., the accounts of the crisis of Merrill Lynch in Morgenson (2008) and of Citigroup in Dash

and Creswell (2008).

65

The ABX consists of five indices, each made up of one tranche from each of the 20 largest recently-

issued subprime ABSs. (The 20 tranches making up the AAA ABX index all had initial ratings of AAA, and there are similarly-constructed AA, A, BBB, and BBB- indices.) Buying and selling protection on an ABX index means entering into a credit default swap on the aggregate of the tranches making up the index in question. The swap is a pay-as-you-go swap, meaning that instead of the swap terminating after the first credit event (writedown, interest shortfall, or principal shortfall) the

63 traders to profit from declines in the perceived creditworthiness of subprime ABSs, and, crucially, made public the effects of them positioning themselves to do so. As the cost of buying protection on an ABX index rises, the level of that index falls, thus making visible the decline in perceived creditworthiness. Buyers of protection included hedge funds anticipating the consequences of the bursting of Americas housing bubble,66 and the most prestigious of the investment banks, Goldman Sachs, which also largely liquidated its mortgage-related positions prior to the full onset of the crisis, absorbing losses in so doing (Tett 2009a, p. 170). Other banks that were heavily involved in ABSs and ABS CDOs typically retained or even continued to add to their positions, but they also began buying protection on the ABX as a way of trying to hedge their exposures.

The result of a greatly increased demand for protection was that the ABX indices fell sharply early in 2007, and then again from the late spring onwards. By early 2008, their levels implied the expectation of almost total capital losses on the BBB and BBBtranches of the subprime ABSs they covered, and very large losses even on higher tranches (Fender and Scheicher 2008). The banks that had warehoused ABSs and retained tranches of ABS CDOs generally held them in what are called their trading books, which meant under current fair value accountancy regimes that they had to be marked-to-market: i.e. revalued as market prices changed. The ABX provided a
protection seller continues to make payments to the buyer as the 20 tranches experience such events, and the protection buyer may need to make payments to the seller if, e.g., an earlier interest shortfall is later made good. Originally, a new set of benchmark ABSs was selected each six months, so creating a new series of the ABX. This ABX index roll was suspended in December 2007 because too few new ABSs were being issued (Creditflux 2007), and it has not subsequently resumed.
66

The New York hedge-fund manager John Paulson is believed personally to have made over $3

billion in 2007 from trading of this sort (Zuckerman 2008).

64 market that could be used to do just that. There was fierce dispute as to its adequacy ABX and TABX [its tranched version] dont really count as grown-up markets. The market participants needed to create proper two-way flows in ABX remain elusive (Hagger 2007) and there were accusations that even though tradeable credit indices apparently were canonical-mechanism markets, they could actually be manipulated (Hughes 2008). However, there was strong pressure from auditors (fearful after the scandals and criminal convictions earlier in the decade, notably concerning Enron and WorldCom, of any impression that they are going soft on clients) to use the levels of the ABX to value banks holdings of recently-issued ABSs. Its cover-your-ass stuff, said one critic of the practice, but it meant that Banks that mark assets far from where the indices trade incur the ire of their auditors (anon. 2008, pp. 95-96).

In the background to the controversy over whether the ABX provided an adequate guide to the value of banks ABSs and ABS CDOs lay the most crucial valuation question of all: whether those banks actually remained solvent. One interpretation was that banks primarily faced temporary problems of liquidity: difficulty using their portfolios of assets as collateral for their borrowing, and difficulty selling those portfolios at any other than distressed prices. The other seldom voiced publicly until fall 2008 (though see de Grauwe 2008) was that the value of the assets of many leading banks had fallen below that of their liabilities, which implies insolvency. Uncertainty on the issue hampered government responses to the growing crisis: the measures required by an insolvent banking system are quite different from those sufficient to ease a temporary liquidity problem.

65 With the unresolved controversy over the adequacy of the ABX as a guide to value, with banks balance sheets notoriously difficult (even at the best of times) for outsiders fully to comprehend, and with the situation changing fast, there was no a priori way of knowing which interpretation was correct. In the end, however, an older, simpler process resolved the ambiguity. The bankruptcy of Lehman Brothers (a particularly large presence in the ABS market) on September 15, 2008 decisively shifted the balance between the interpretations. The bankruptcy was triggered by Lehman in effect simply running out of money, for example because other banks stopped lending to it via repo, leaving it unable to meet its obligations.67 The underlying process was Robert K. Mertons self-fulfilling run on a bank (Merton 1948). The collapse of Lehman was a collective disaster for the banking system since it crystallized the view that many of the worlds leading banks were insolvent but it was in each banks individual interest to stop lending to Lehman to reduce its exposure to a Lehman bankruptcy. Their doing this brought about the latter, and triggered the global banking crisis.

Conclusion

In the introduction, I suggested that shared sets of beliefs, practices, and technical systems could be classed as evaluation cultures if they had some coherence and some degree of historical continuity, and I suggested that the concept was analytically

67

Repo, often the main funding source for investment banks and some hedge funds, involves lending

money against bonds and other securities such as AAA ABSs that are, in effect, pledged as collateral.

66 interesting if those cultures could be shown to differ in consequential ways. This article has identified two such cultures, respectively surrounding corporate CDOs and ABSs (especially mortgage-backed securities). It has discussed the origins of these cultures and highlighted the way in which they continued to differ, even though the financial instruments on which they focused had very similar structures. The article has shown that the dominant approach to the evaluation of corporate CDOs was for perfectly understandable, pragmatic reasons extended (with only relatively minor modifications) to the evaluation of ABS CDOs, with the result that the highest tranches of the latter were seen as very safe indeed, and in consequence were accumulated in the core of the global financial system by the worlds leading banks.

Although widely shared, that evaluation of ABS CDOs was given particular force by its crystallization in one of the two metadevices discussed here, the ratings system. With the other metadevice, the canonical mechanism, playing a relatively minor role in the evaluation of ABSs and CDOs of ABSs (until the early months of 2007 when, as just described, the ABX moved to center stage), ABS CDOs were known primarily via their ratings. As an interviewee put it to me in June 2006: the whole [CDO] market is rating-agency-driven at some level ... the game is basically to create ... tranches of portfolios which are A, AA, or AAA-rated and yield significantly more than a correspondingly-rated tranche of a corporate or an asset-backed derivative, commercial mortgage-backed security would yield ... its just that there are investors who are constrained by ratings ... and that creates value for everyone else and were in the business of exploiting that.

67 ABS CDOs seemed close to an arbitrage, a risk-free profit opportunity: the arrangers of an ABS CDO could capture for themselves the difference between the cash flow from its asset pool and the payments that needed made to investors. Hence, for example, the continuing huge demand from ABS CDOs for ABSs, even as the terms on which the latter were being sold ceased to reflect what ABS specialists regarded as their intrinsic value: ABS CDOs will not hesitate to bid spreads tighter than can be fundamentally justified so long as their arb can still be made to work (Adelson 2006c, p. 1).

What was being arbitraged by ABS CDOs was, ultimately, a system of knowledge. It was one in which central roles were played by Gaussian-copula models of CDOs, with modest correlation parameters and low default probabilities, and by logistic-regression or hazard-rate models of mortgage defaults in which the coefficients had been estimated using past data. The issue is not primarily that such models were wrong (as is, e.g., argued with respect to the Gaussian copula by Salmon 2009): had they been simply external representations, with no effects on the processes they modeled, they might have remained reasonably accurate. Rather, they were made wrong in part by the processes (especially the ABS CDO assembly line) of which they were an integral part, in the phenomenon I call counterperformativity.

It is worth emphasizing that the influence of the ratings system (and of the arbitrage of that system) can be seen even in areas where the counterperformative processes did not set in. This has been shown by Coval, Jurek, and Stafford (2009), who demonstrate elegantly that patterns of prices in one of the key tradeable corporate credit-index markets, the CDX NA IG, were shaped by the ratings system (in

68 particular by market participants evaluating the spread offered by a CDO tranche by comparing it to the yield of more familiar instruments, notably corporate bonds, with the same credit rating) in ways inconsistent with both modern economic theory and prices in another important market, the market in long-dated options on the main stockmarket index, the S&P 500.68 They conclude that an investor who purchases a AAA-rated tranche of the CDX could earn a yield spread four to five times larger by bearing comparable economic risks in the index options market (Coval, Jurek, and Stafford 2009, p. 629).

Although the specifics of that conclusion are of necessity somewhat sensitive to the asset-pricing model employed, it is noteworthy in its striking inconsistency with
68

The argument of Coval, Jurek, and Stafford (2009) is too technical to be presented here in full, but it

rests on the insight fundamental to the economic theory of asset pricing since the work of Arrow (1964) and Debreu (1959) that there is greater value in the same positive pay-off and greater harm in the same loss in bad states of the world (deep recession, for example, for instance) than in good. For example, according to the well-known CAPM (capital asset pricing model), the price of a financial instrument with high systematic risk that is, one whose performance is highly correlated with overall market conditions has to be such that the instrument offers higher expected returns than one with a low correlation, if investors are going to be prepared to hold it. Ratings, however, do not seek to capture the systematic risk of an asset in this sense, but rather its total risk, systematic and unsystematic, as indicated by its default probability (in the case of S&P and Fitch) or expected loss (Moodys). As Coval, Jurek, and Stafford show, this has the consequence that an evaluation culture in which values are inferred directly from ratings will overvalue instruments whose risk is primarily systematic, such as CDOs (the diversified nature of the asset pools of CDOs minimizes idiosyncratic, unsystematic risk), relative to those such as corporate bonds which have the same total risk (e.g. the same default probability) but where that total risk has a large unsystematic component. Note that this effect holds even if the rating agencies are able to estimate default probability or expected loss with complete accuracy.

69 the efficient market hypothesis. It also helpfully contextualizes the research reported here in two respects. First, the components of the CDX NA IG are 125 leading North-American domiciled investment-grade corporations, and there have been no real analogs in that market of the counterperformative processes identified in this article.69 So the influence on patterns of prices of the ratings system seems detectable even in the absence of those processes.70 Second, both the CDX NA IG and S&P 500 index options are well-established, liquid, canonical-mechanism markets, so demonstrating that it would be wrong to imagine that the influence of the ratings system is restricted to markets in which the canonical mechanism is absent.

The comparison with option trading is also useful in a different way. It suggests that this articles findings are not susceptible to a simplistic rational-choice gloss, and that evaluation cultures and organizational processes really did matter. In the key period (2002-7), banks were certainly under considerable stockmarket pressure to increase profits (particularly as measured by return on equity) even if it meant taking on huge extra risks, and it is also plausible but in fact has not so far

69

Lending to sub-investment-grade corporations did become substantially less cautious because of the

capacity to sell on those loans to CDOs, but any such effect in investment-grade lending was much attenuated.
70

The influence of the ratings system on CDX NA IG spreads was probably not as direct as Coval,

Jurek, and Stafford (2009) suggest, in that my interviews indicate that those most active in index markets such as the CDX used their own models rather than relying on ratings. However, those models, whose developers were usually trained not in economics but in mathematics or in highly mathematical areas of the sciences, also generally sought to capture total risk, not systematic risk (see note 68). In addition, interviewees reported that index prices were heavily influenced by the creation, hedging, and unwinding of rated instruments.

70 been demonstrated unequivocally in the literature on the credit crisis that some traders sought to maximize their bonuses even when they knew that if things went wrong the losses would imperil the banks that employed them. Yet there was at least one other similar way of boosting profits and bonuses: selling deep out-of-the-money index puts, in other words option contracts that require their sellers to make large payments to the buyers should stockmarkets fall precipitously. Like buying or insuring the super-senior tranche of an ABS CDO, selling a deep out-of-the-money index put brings in a regular income, and it is also subject to a low-probability but potentially catastrophic loss. If the conclusions of Coval, Jurek, and Stafford (2009) can be extended to this case, selling out-of-the-money puts would actually have been a better strategy than buying or insuring super-senior ABS CDO tranches.

Yet the latter was widely practiced and the former stigmatized. I discussed the comparison with a senior figure in a bank that suffered calamitous ABS and ABS CDO losses, and what he said indicated that whatever the pressures to increase profits or the temptations to pursue bonuses at all costs large-scale put selling would simply not have been tolerated by the different department of the bank responsible for derivatives such as options. The culture of professional options trading had become, ever since the 1987 crash, hugely sensitive both to the risks of unhedged put sales and to the difficulty of hedging them adequately, as shown in [author ref]. (An interviewee for this previous research said of those who sold unhedged puts, We call them the shit-sellers!) In contrast, I have found no unequivocal evidence of anyone having fully perceived, prior to the crisis, similar risks in super-senior ABS CDOs. Greed the egocentrically-rational pursuit of profits and bonuses matters, but the calculations that the greedy have to make are made within evaluation cultures.

71

As historical sociologists of science have long known, hindsight is the chief methodological enemy of the sociology of knowledge. With the pre-crisis evaluations of ABS CDOs having now been shown to be so radically wrong, it is difficult to recapture the cognitive world in which they continued to seem plausible even as the US housing market began to crumble. Here, the peculiar status of the ABS CDO as what one might call an epistemic orphan cognitively peripheral to both its parent cultures, corporate CDOs and ABSs may be of relevance. As noted above, the first interviews for the research reported here were conducted in 2006 and early 2007, before the crisis, and they were with members of the evaluation culture of corporate CDOs. They had their concerns one rating-agency employee reported: Some investors have said ... to us ... does a AAA mean the same thing as it meant five years ago? but to the extent that those concerns had a specific focus it was a sophisticated product called a CPDO (constant proportion debt obligation), not the vastly bigger volume of the boring ABS CDOs. Similarly, Adelsons conference reports (in particular Adelson 2006b, c; Adelson 2007a) reveal widespread awareness amongst ABS specialists of growing problems (and high levels of fraud) within the US mortgage market, but not the perception that the apparently safe ABS CDOs were exquisitely exposed to those problems.

I do not claim that the processes identified in this article are the cause of the credit crisis. For example, the article has not examined investor demand for ABSs and CDOs, which was fueled by a search for yield: the attractiveness, in a regime of low interest rates (themselves in part the result of a savings glut caused by imbalances in world trade), of the extra spread that ABSs and CDOs offered (see, e.g.,

72 Turner 2009). I have not sought to disentangle the contribution to the processes identified here of the broader bubble mentality that developed in the US (and several other) housing markets and in much of the global banking system from around 2003 onwards. The article has not discussed the interaction of mortgage securitization and the housing bubble: rising house prices held down defaults (and thus disguised the growing deterioration in the process of mortgage origination), because home owners in financial difficulties could pay off their existing mortgages by selling their house, or simply by taking out new, larger mortgages (see, e.g., Gorton 2008); and securitization helped house prices to keep rising because it increased the availability of mortgage finance (Mian and Sufi 2008). Nor have I investigated the on-the-ground relationships between ABSs, subprime lenders, and Americas poor and middle-income families. Because of the articles focus, it has concentrated on consequences for banks and investors, but the crisis has also been a disaster for millions of Americans, and has painful costs largely still to come for many others worldwide.

Nevertheless, I hope that in its focus on the evaluation cultures and metadevices at the heart of the credit crisis, the article has thrown some light on that crisis, and has also shown that attention to these matters is of interest to economic sociology more generally. If nothing else, the crisis has shown how dangerous it can be (for example to public policy) to assess market processes in abstraction from the cognitive and organizational reality of those cultures and metadevices. In April 2006, the IMF noted: There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than

73 warehousing such risks on their balance sheets, has helped to make the banking and overall financial system more resilient. (IMF 2006, p. 51)71 As we now know, quite the opposite was in fact happening. Driven by the evaluation cultures discussed here (and specifically by negative basis trades and ABS CDO assembly lines and warehouses) risk was being accumulated, not dispersed, and the financial system was growing more fragile, not more resilient. There can surely be no more vivid demonstration of the need for a broadening of the disciplinary basis of research on financial markets, and in that broadening economic sociology has a vital role to play.

71

In fairness to the IMF, I should acknowledge that it did point out that while pricing data are

relatively easy to obtain ... measuring the degree and effectiveness of risk transfer continues to present statistical and methodological challenges (IMF 2006, p. 78)

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S&P AAA AA+ AA AAA+ A AInvestment Grade BBB+ BBB BBBSpeculative Grade BB+ BB BBB+ B BCCC+ CCC CCCCC C Defaulted Figure 1: rating grades D

Moodys Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C

87 Fitchs grades are identical to S&Ps, except that Fitch employs a single CCC grade with no + or modifier. Sources: http://www2.standardandpoors.com; http://v3.moodys.com; http://www.fitchrating.com. All accessed August 20, 2009.

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senior tranche

mezzanine tranche

equity tranche

Figure 2: the structure of an ABS or CDO (highly simplified). Unless otherwise indicated, all the instruments described in this article have this structure, though the number and relative size of the tranches varies, and sometimes other forms of credit enhancement are employed in addition to tranching (see note 41). As noted in the text, investors in the lowest tranche (sometime known as the equity tranche) bear the greatest risk of loss of capital and receive the highest spreads (interest rates). The higher tranches carry less risk but offer lower spreads.

89

AAA

81%

AA

11%

4%

BBB

3%

BB, NR

1%, not in all deals

Other credit enhancement: excess spread, overcollateralization

Figure 3: schematic structure of a typical subprime mortgage-backed security. Source: Lucas (2007). Note that the overall size of the tranches is not shown to scale. BB, NR means either rated BB (speculative grade) or not rated. See note 41 for the meaning of excess spread and over-collateralization.

90 High-grade ABS CDO

Super-senior AAA

88% 5% 3%

AAA Subprime mortgage-backed securities AAA 81% 11% A A BBB 4% 3% Mezzanine ABS CDO BB, NR 1%, not in all deals
Super-senior AAA

AA

2% 1% 1%

AA

A BBB

BB, NR NR

62% 14% 8%

Other credit support: excess spread, over-collateralization

AAA

AA

A A BBB BB, NR NR Other credit support: excess spread

6% 6% 4%

Figure 4 Packaging tranches of subprime mortgage-backed securities into ABS CDOs. Source: modified from Lucas (2007). Tranche sizes not shown to scale. NR means not rated.

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AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B B-

original version November 2001 0.25 n.a. 0.50 n.a. n.a. 1.00 n.a. n.a. 2.00 n.a. n.a. 8.00 n.a. n.a. 16.00 n.a.

version 3.0 December 2005 0.079 0.123 0.231 0.299 0.396 0.488 0.708 1.243 2.020 4.089 7.198 10.370 14.171 18.062 23.249 31.107

version 3.2 June 2006 0.116 0.168 0.315 0.407 0.468 0.576 0.798 1.357 2.203 3.000 n.a. n.a. n.a. n.a. n.a. n.a.

Table 1 Default probabilities (percents) over seven-year period of ABSs with given ratings, as assumed in three versions of S&Ps CDO Evaluator. Sources: Bergman (2001); Gilkes, Jobst, and Watson (2005); Adelson (2006a). The original version employed time-independent default rates (see note 57), but assumed a seven-year weighted-average life for ABSs (Bergman 2001), so the seven-year default probabilities in the later versions are most closely comparable.

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AAA AA+ AA AAA+ A ABBB+ BBB BBB-

CDO Evaluator three-year default probability assumptions, as of June 2006 (percent) 0.008 0.014 0.042 0.053 0.061 0.088 0.118 0.340 0.488 0.881

Realized incidence of default, as of July 2009 (percent) 0.10 1.68 8.16 12.03 20.96 29.21 36.65 48.73 56.10 66.67

Table 2 CDO Evaluator three-year default probability assumptions versus realized default rate of US subprime mortgage-backed securities issued from 2005 to 2007. Sources: Adelson (2006a); Erturk and Gillis (2009).