Sociology of Wall Street Key Concepts
Explain the formula that "to arrive" contracts + standardized grading ⇒ futures markets. (To do this, you should define both "to arrive" contracts and standardization.)
"To arrive" contracts: agreements where someone purchases a certain amount of a product (wheat) that is promised to be delivered on a certain date; eliminated uncertainty about wheat prices for farmers and shippers Standardization: certain types of grain had to conform to certain criteria in quality and aspects that marked them a certain rating; standardized quality grades subdivided the overall supply of wheat, making it possible for a group to buy up a large portion of the market supply in a particular grade or "corner the market" (without grades, wheat supply is too large to corner) -This formula means that people could buy quantities of wheat at a certain price some time prior to when they would be delivered; because types of grain were standardized, those buying the "to arrive" contracts could be sure that they would receive a certain quality of grain that they paid for
How do investment banks and investment bankers maintain their status in relation to corporate America?
-Bankers use hard work to differentiate themselves from other workers (back-office workers, workers in corporate America, low-wage workers, etc.) -Bankers see themselves as hard-working, ambitious, surrounded by the best people, and ready to take risks -Bankers frame corporate America as slow and lazy (this is a myth--lower-middle-class workers often work more hours and for less pay than anyone) -Bankers' own percieved "smartness" and ability to remake corporate America in a more efficient way creates a moral rationale for the high status and high pay investment bankers have
How did the hostile-takeover movement succeed in creating a market for corporate control?
-Gave ownership and power to proponents of shareholder value, allowing them to implement new corporate practices -The threat of takeover was enough to get corporations to implement the things that shareholder-value proponents wanted (executive compensation, board independence, accountability to outsiders) (if didn't, company would face a hostile takeover, and manager would be fired)
Why is it so hard to bet against the housing market (and the housing bubble), and how did traders solve this problem in the mid-2000s?
-Hard to continue putting up the money to short the stocks of companies involved in the market (mortgage lenders, construction companies, etc.) if the stock prices keep rising for too long; bet might end before it pays off, even if you're right in the long run -if prices rose very high very quickly, losses can be unlimited -shorting asset-backed bonds like mortgage bonds were problematic because unlike stocks, which are easy to borrow, each mortgage bond represents a unique pool of mortgages, so it's impossible to borrow against a specific bond; can't sell them short/bet against mortgage bonds -Changed in mid-2000s when traders at Morgan Stanley invented credit default swaps (CDS): insurance on a mortgage bond--the buyer makes small payments, and the seller pays the full value of the assets in the event of a default--provided a way to bet against mortgage bonds because they're essentially an insurance policy (buyer of CDS makes payments to seller as long as underlying debts of mortgages are still out there, seller of CDS insures against default--if asset defaults, seller will pay full value of bond back to buyer, so person who bought CDS gets money if they default; earns money if housing bubble crashes)
How do performance evaluations contribute to the gender pay gap? (I.e., why are performance evaluations not objective?)
-Homophily (here, same gender) between managers and workers and among managers leads to better ratings -Since men still outnumber women by a long way in the highest positions of power, this produces gender differences in wages -When people are told that firms have anti-discrimination policies (as on Wall St), whites and men become blind to discrimination -even if firms use math formulas to produce ratings, managers interpret the scores subjectively to favor the workers they like -managers don't like being told whom to promote and pay well, and they can shape the performance evaluations to fit their own preferences (so evaluate women lower so they're not promoted/paid as well)
How do arguments in favor of shareholder value depend on the efficient market hypothesis?
-Morally say that companies maximize social welfare by maximizing profits. Argued that if share price provides the best estimate of future profits (according to the EMH), then companies maximize social welfare by maximizing their share price
Why are mortgage bonds and CDOs safer than the individual mortgages they contain, and what is the key assumption that must be true for them to be safer? (Hint: how are bonds and CDOs like insurance?)
-Mortgages themselves are risky because the mortgage holder can either default (fail to make payments) or repay their mortgages too quickly, so the "investment" ends too quickly for the mortgage seller -mortgage bonds are safer because they are divided into tranches--lowest tranche means its riskiest, highest tranche is safe (unless underlying mortgages made prepayments); pooling risk into mortgage bonds means investors can protect themselves against mortgage default even if loans aren't backed by govt. -CDOs are even safer because some mortgage bonds were junk bonds or poorly rated bonds based on subprime mortgages; CDOs carved up mortgage bonds into tranches and repackaged them as less-risky securities--the more BBB bonds are packaged together, the safer, because low probability of everyone defaulting, so could rate it higher -Key assumption that must be true for CDOs and mortgage bonds to be safer (similar to insurance agencies) is that some of the assets you insure might go bad, but they won't go bad all at once; probability that one person defaults on their mortgage is not correlated with probability that any other person defaults on their mortgage--i.e., subprime mortgage defaults were uncorrelated (not true...)
What does it mean to say that markets are socially constructed institutions? (This is a key unifying idea of the course.)
-People ("actors") behave within networks and institutions that the people themselves continuously create (and re-create) -Through interaction, people construct norms, scripts, and strategies that guide their future behavior -Market making is different on the NYSE, the CBOT, and in bond markets, because market makers are embedded in different social contexts -rational maximizing is interpreted differently on these different markets -they are institutions because they are a collection of stable rules and relationships that make trading possible -market makers are embedded in multiple, overlapping communities operating at different institutional levels (e.g, banks, stock exchanges, groups of other market makers) -markets don't emerge spontaneously from people trading; trading takes place within stable institutional arrangements (institutions define the market, not other way around) -markets are shaped by conflicts between powerful actors trying to build markets to their advantage
Why are racial minorities more successful in product-side jobs than in relationship-side jobs?
-Product-side areas are more focused on technical skills, and they are seen as more meritocratic, so they're often only jobs open to racial minorities; Asians are stereotyped as quantitative and technical and are pushed into product-side roles -Relationship-side areas depend heavily on workers' individual cultural capital for success, which puts racial minorities at a disadvantage -when "social skill" is dependent on characteristics attached to race, then it creates racial disadvantage (ex: golf)
Explain this statement: If all investors believe in the efficient market hypothesis, the market cannot be efficient
-Reflecting all available info: If everyone believes in EMH, and thus believes prices reflect al available info, there's no incentive for anyone to collect info, and markets will be less efficient as a result -Assuming arbitrage is irrational: if all investors assume arbitrage is irrational (because prices already reflect true value under EMH), then no one will engage in arbitrage, and the market loses its mechanism for bringing prices in line with values (arbitrage profits would only be available to investors who don't believe in EMH)
For what purposes are stocks primarily used? (Hint: they're almost never used to raise capital for the corporation issuing the stock.)
-Stocks allow founders/owners to transfer ownership (and cash out) -Stocks are speculative investments (investors hoping the price increases) and an income stream (dividends) -when you buy stock, the money goes to other owners, not to the company itself (corporations typically get money for investment through credit) -shareholder value has turned the stock market into a market for corporate control
How are mortgage-backed CDOs a form of arbitrage?
-The basic principle behind CDOs is arbitrage: buying a product on one market and then selling it (often instantaneously) on another market at a higher price, creating guaranteed profit -Corporate CDOs took high-yield (high-interest) corporate bonds (with lower ratings) and packaged them into low-yield (low-interest) (but safer) CDOs -This was the trick of turning BBB bonds into AAA CDOs; since interest payments on corporate bonds were greater than what the low-yield CDOs paid out, banks could profit from the spread between these rates (arbitrage)
What caused options prices to converge towards the predictions of the Black-Scholes-Merton model, at least until 1987?
-The model played an important legitimating role for early options exchanges -the model ultimately had simplicity on its side: the model only has one parameter (volatility) that traders had to reason about, and it was something they understood intuitively from their own floor experience -the cognitive simplicity of the BSM, its public availability, and the idea of using paper price sheets made it possible for the model to gain a foothold on the trading floor, despite early skepticism -the BSM model encouraged particular trades that formed the foundation of testing the theory -securities regulations caught up with the assumptions of the model, and that further brought prices in line with the theory -gradually, people stopped thinking about trading options and instead started thinking of themselves as trading volatility (the key parameter in the BSM model: options on more volatile stocks were worth more, so options are really bets on how volatility is going to change) -BSM itself became part of the trading process -basically, the reason prices converged towards the prices created by the BSM model was because the market performed the economic theory of the BSM model (means using some aspect of economics to guide your behavior in a market eventually makes the market look more like the way economics depicts it) -USING THE bsm MODEL OF OPTIONS PRICING TO TRADE OPTIONS EVENTUALLY CAUSED MARKET PRICES TO FIT THE MODEL
How did shareholder value inadvertently encourage accounting fraud?
-The new concept of "making the quarter" created an intense need for corporations to hit earnings targets set by securities analysts and institutional investors, so corporations started lying about their earnings -The goal was to make it look like their earnings will rise steadily at a constant rate forever, so they overstated earnings in bad years and understated in good years with the help of big accounting firms -makes sense that this is a consequence, because executives wages were tied to stock price now, which was tied to profits, so executives had incentives to lie about profits
Why is there a tradeoff between opportunism and restraint, and how do traders solve this problem?
-There's a tradeoff between opportunism and restraint because traders want to make as much money as they can, but if there's too much cheating, no one will want to do business with them -Tradeoff between short-term self-interest and long-run survival of the market -Traders solve this problem by creating "fair" competition by constructing and maintaining it by setting rules as to what is and is not okay, and what's a gray area
How have investment banks pushed the bulk of their downside risks onto their workers and onto the state?
-Through bonuses--bonus system helps banks minimize their own risk: because 50% of costs in big investment banks are labor costs (how much pay their workers), by keeping salaries low and paying most compensation as bonuses, banks gain control over their fixed costs--when things go wrong, can just cut bonuses instantly, allowing them to remain profitable; risk of financial trouble is bourn by workers, no the banks themselves -By profiting on deals, not the success of deals, and by paying bonus-heavy compensation that can be cut at any time, banks reduce their downside risk; in times of recession, there are fewer deals, so banks suffer but they're largely insulated--recessions create their own deals through corporate restructuring and bankruptcies -investment bank culture focused on being "one with the market" forces them to adapt very quickly to changing market conditions -since banks were so big, market couldn't afford for them to fail, so state would bail them out, as seen in 2007
What key developments were necessary for high-frequency trading to succeed? (Hint: talk about how Reg NMS combined with market fragmentation to make speed important.)
-fear of front-running led to new market rules: Reg NMS required brokers to execute orders at the "best price" -Reg NMS set up the National Best Bid and Offer (NBBO) system, which defined what the best price was -NBBO was implemented via the Securities Information Processor (SIP), which aggregated prices from every different stock exchange to determine the current market price -Reg NMS was designed to create equality of opportunity in the market and prevent front-running; instead, gave big advantages to traders who could operate more quickly (because SIP was too slow and clunky) -HFT firms needed to be faster than SIP to succeed (could see the market 25 milliseconds ahead of when ordinary investors saw it) -Market fragmentation: development of many more markets; used to be just NYSE, but then Nasdaq entered and by 2007 there were 13 different stock exchanges -Since Reg NMS forces trades to be filled across multiple exchanges, HFT firms can now see trades on one exchange and then try to beat the rest of the order to other exchanges (the proliferation of exchanges is great for HFT)
How has financialization contributed to U.S. income inequality?
-financialization shifts money away from workers and production and into financial activities and financial markets (decrease in production-related investments, which stagnates non-financial growth; also more bargaining power to owners and elites relative to workers, so workers excluded from bargaining process) - financial income is independent of the production workforce (more productivity doesn't mean higher wages anymore) -institutional shift: finance is now more culturally valued in the US than ever before (means easier to justify high wage concentration and devalue low-wage work)
Why did corporations shift towards large, diversified conglomerates in the 1960s and 1970s?
-firms sought corporate growth because manager pay was tied to size more than profit -big companies were invulnerable to takeover and rarely failed -There was growing concern in the 50s and 60s about oligopoly, so new antitrust legislation made it more difficult to grow within your own industry by buying competitors and suppliers, so diversification became the only path to growth
Why did electronic markets start paying brokers to trade on their exchanges, and what were the consequences of this?
-many exchanges started paying brokers to bring their trades to the market because exchanges sold speed to HFT firms, but HFT would only pay if there was a large stream of orders from which they could profit -consequences: conflict of interest for brokers, because they want to collect fees, even if it means hurting their customers; also, payments for trading were meant to encourage liquidity, but HFT firms figured out how to get paid for trading without actually providing any liquidity
Explain Keynes's famous statement: "The market can stay irrational longer than you can stay solvent."
-means investors can't focus on the intrinsic value of assets but must instead focus on what everyone else thinks the asset is worth (its price, not its value) -Keynesian beauty contest: have to guess what everyone else will think is the 6 prettiest faces -the reason bubbles can exist and arbitrage doesn't prevent them is because people assume others will keep betting on prices going up, so even if they think they're overvalued, they will keep betting on them rising
How did the organizational structure of ratings agencies contribute to the miscalculation of risk when they rated CDOs?************************************** CHECK THIS ANSWER!!!!
-nobody wanted to take responsibility for rating the ABS CDOs (ABS ratings agencies or CDO agencies); the two-step rating procedure (securitization groups rated the mortgage bonds and then derivatives teams rated the CDOs) that used ratings of ABS groups and left responsibility to CDO groups to rate the overall ABS CDO was the result of a particular organizational structure -also, the correlation between defaults was handled by organizational procedures rather than mathematical risk modeling--stress tests continued to be used based on mortgage pools, even after individual-mortgage-level analysis were available, and geographical clustering of mortgages and other risk factors were handled using coarse penalties rather than incorporating these factors into a risk model
Describe three mechanisms through which cultural capital leads interviewers to hire people similar to themselves.
1. Cultural fit: candidates should be similar to a firm's existing workers (leisure activities, background, self-presentation) because the jobs have time commitments and travel, so interviewers want to enjoy spending time with them, and employers want to minimize turnover and figure people who "fit in" won't leave 2. Cognitive processes: easier for interviewers to evaluate people who are similar to them (people who went to same university: know the standards/strength of its majors, people who worked for similar, high-status employers); individuals construct merit to mean people who are similar to them (if I had same experiences and I was successful, they will be too); through this process, firms reproduce characteristics of their own workers 3. Emotional processes: hire candidates they feel an emotional spark with; emotional connections can overshadow hard differences, excusing deficiencies; emotional excitement depends on shared cultural capital
Describe four mechanisms through which elite universities funnel undergraduates into careers.
1. Lack of information: incoming college students don't have enough info about all possible career paths open to them, and there are high expectations and motivation but little concrete direction; also, most students don't know a lot about finance/consulting. This lack of info means campus influences (peers, student organizations, career-planning offices) can have big effects, so students learn a ton about careers they never imagined being interested in 2. On-campus recruiting: recruiting fuels competition for prestigious jobs; particularly at elite colleges, students are used to succeeding in structured competitions (like admissions), and banks and firms host lavish receptions and hold interviews that show the competition and its rewards to draw these students in. Finance and consulting dominate recruitment at Harvard (tech is bigger at Stanford), and career centers have way more events devoted to applying to finance and consulting jobs, as opposed to other careers 3. Social expectations and insecurities: elite students feel they have to live up to expectations of university and peers by landing elite jobs (Wall St jobs=prestigious and elite, shows student's individual worth and success if land one); elite jobs are also seen as "safe" because they offer a few years to build wealth while hoping to later transition to other careers that "change the world" 4. Status boundaries: students learn to distinguish between high-status and ordinary jobs (they learn that high-status jobs require degrees from elite universities, they recruit on campus, and they have characteristics similar to the most highly visible jobs like finance and consulting)
Why did opportunism thrive in the bond market in the 1980s?
1. No face-to-face relationships: since the bond market is over-the-counter, trades happen through computers or phones or through intermediaries, which creates a weak reputational network--harder to enforce norms 2. Trades are separated from their customers by the sales force: traders feel little obligation to either salespeople or their customers 3. The most opportunistic firms provide the most profits, so customers accept some degree of opportunism 4. Traders believe that customers expect them to be opportunistic, but customers can't predict which trades they'll get cheated on -limited formal (legal) controls: 1980s was period of low enforcement of SEC rules -traders have private info about state of market and about customers
Explain the three crises that the state faced in the 1970s that set the stage for financialization. (You should be able to explain each crisis in a sentence or two—not a lot of detail needed here.)
1. Social crisis: after WWII, the state increasingly distributed wealth to all social groups in the economy, but economic slowdown in 70s required this to be scaled back. However, all groups continued to demand the same resources, so rising inflation allowed the state to say no without doing so openly, because inflation diluted the cost of social expenditures; inflation was a self-reinforcing cycle: capitalists raise prices to increase profits, workers demand higher wages, capitalists raise prices again 2. Fiscal crisis: political pressure on the state to compensate for declining incomes in the 70s created expenditures too large to be paid by tax revenues. The state was increasingly expected to fund inputs to the economy like physical infrastructure, human capital, and demand for products. This spending benefited private industry, but industry was unwilling to pay for it through higher taxes. Social unrest also created demand for more state spending, and deficit spending then furthered inflation and strain on state 3. Legitimation crisis: failure of the state to deliver on its spending commitments caused a loss of confidence in the state. State expansion into the economy also meant that the state was increasingly blamed for any economic problems (instead of attributing those problems to the business cycle)
Name at least three arguments that proponents of electronic trading made against open-outcry (pit) trading, and explain how pit traders responded.
1. lower costs and fees: electronic trading eliminates many commissions and fees, giving customers cheaper access to trades -pit traders argued their fees are valuable, because they preserve market stability, liquidity, and trust 2. faster trades: electronic ordering dramatically speeds task of carrying out a trade -pit traders argue hybrid systems can take advantage of this, too--traders want to preserve trading but allow electronic systems to take place of clerks, runners, and back-office staff (network-backed power conflict) 3. Liquidity: electronic markets mean greater liquidity because increases number of traders in the market (anyone with computer can trade--market becomes global) -pit traders say don't need that because Chicago markets are famous for providing liquidity because pit provides speculators and market makers who will always trade, and the narrower bid/ask spread under electronic trading limits ability of market makers to make profit
Describe three consequences of the end of managerial capitalism (for corporations or for workers).
1. the end of the lifetime-employment model: workers were now free-agent contractors, which meant job insecurity and people worrying about being laid off; people also no longer had defined-benefit pension plans, but rather 401(k) plans for retirement because it was portable from job to job, and individuals could handle their own investments and depended on the broader health of the market 2. the decline of internal labor markets and "entry-level" jobs: entry-level jobs have been contracted out, so they no longer act as a starting point for promotion and upward mobility; causes lower economic mobility and greater inequality; corporate pay systems also no longer share benefits at all levels of employment (now the pay at the top is unconstrained, since lower levels of hierarchy are gone--high levels of income inequality between owners and executives at the top and workers at bottom) 3. the end of corporate welfare: workers now pay a large share of their health-care costs, individuals are responsible for own retirement, and wages have stagnated for all but top earners; credit also replaced corporate welfare
Explain arbitrage as association/commensuration: how does it differ from classical arbitrage, and how do traders discover opportunities?
Arbitrage as association/commensuration: -doesn't guarantee profits--traders have real risks and losses -relies on identifying different strategies of evaluation that don't match -like classical arbitrage, it's based on comparisons between 2 particular assets that are related in some way; assets have to be similar enough that the trader can predict how their prices will change in relation to each other but different enough that other traders have not yet discovered this relationship ex: CDOs and mortgage bonds underlying those CDOs, futures with options How traders discover opportunities: -exploration and exploitation in trading room -arbitrage depends on both exploitation and exploration: have to recognize when potential trades fit an existing pattern that the trader knows how to arbitrage, and have to look for new kinds of associations that can be used to find new arbitrage strategies -get these through social interaction in trading room, meeting new people and getting new opinions/exposure, connect with people from different desks who see market through different lens -experiment with new ideas about association between two things and see if experiment works (i.e., it makes a profit)
What are the limits of arbitrage and learning in markets?
Arbitrage limits: -when prices are low (undervalued), a value investor can buy a corporation outright if she thinks the value is much higher than the price, but when prices are high (overvalued), there's no comparable strategy -you can sell a stock short, but in the internet (dot-com) boom, there often weren't enough shares to borrow; short-selling also puts you at the mercy of the speculative market--you'll often go broke before your bet pays off Learning limits: -if prevailing theories of value are wrong (i.e., we're in a bubble and prices aren't correct), then those who recognize this can't do anything to correct it; since those with correct theory will simply avoid the market, short-term prices will be set by those with the incorrect theory, so the bubble will just continue to inflate -these limits are rooted in the limits of value-price arbitrage; bears have few options to express their disagreement with market prices bc everyone else is going to keep betting on prices rising
How does economic and social capital give children of wealthy parents an advantage in school/college success?
Economic capital: parents' wealth gives children access to better primary and secondary schools, access to better resources and activities that elite schools value (test prep, APs, college counseling, extracurriculars), help with college affordability (wealthier students choose colleges based on noneconomic factors), and parental financial support during college (students are less likely to work) Social capital: elite parents' social connections open doors for their children in jobs, etc.; also, students' resulting elite social networks also create opportunities because they shape student aspirations, promote shared learning, and provide information about college admissions and career opportunities
According to Fligstein, Brundage, and Schultz, how did framing and positive asymmetry cause the Federal Reserve to fail to anticipate the financial crisis?
Framing: -the dominant frame used by the Fed was based on macroeconomics, particularly the new neoclassical synthesis -because they all had the same frame that was based on macroeconomics, the FOMC stayed optimistic in the bad economic news because they saw the economy as self-regulating; figured problems would solve themselves -FOMC viewed the real economy as separate from the financial system (didn't believe problems in the housing market and financial system would spill over into other parts of the economy) -macroeconomic frame caused the FOMC to ignore the importance of financial markets and treat any signs of danger as self-correcting Positive asymmetry: -the FOMC was biased towards best-case scenarios, and reinterpreted negative info in a positive light; discarded worst-case scenarios (like believing the housing bubble wasn't a bubble) -they interpreted dangerous economic signs as normal -intense spike in housing prices was explained away as resting on "strong fundamentals" -FOMC members rationalized negative scenarios even in a meeting specifically aimed at evaluating housing risk (June 2005) -continued to believe it was a short-term fluctuation that wouldn't spill over into broader economy
How did real, material structures enable opportunism and hyper-rationality in 1980s bond markets?
In the pit of the CBOT, traders that had more experience would stand on the upper tiers of the pit, and new and inexperienced traders would sit at the lower levels of the pit until they moved up. Those at the bottom had little exposure and couldn't do as many trades as those at the top Opportunism: -limited formal (legal) controls: 1980s was period of low enforcement of SEC rules -limited informal controls: weak social relationships among traders -asymmetric info: traders have private info about market and customers Hyper-rationality: -continuous flow of info -high uncertainty about prices, appearance of bids/offers puts limits on prediction, which encourages vigilance (maximum accuracy) but also intuitive leaps in decisions -high-stakes outcomes make deliberate, exhaustive calculation worthwhile
Contrast the moral rationales used by proponents of managerialism with those used by proponents of shareholder value.
Managerialism proponents thought of companies as social institutions who have a duty to look after their workers, customers, communities, and society more generally. Shareholder value proponents believe that companies maximized social welfare by maximizing profits.
Who are the winners and losers in high-frequency trading, and how does each one make or lose money?
Winners: HFT firms, big brokers who sell access to their orders and to their dark pools and who run their own proprietary trading desks, and electronic exchanges paid by HFT firms for access to speed Losers: "ordinary" investors aka people trading stocks through retail accounts, and many kinds of institutional investors like mutual funds, who depend on brokers to execute their orders
How do futures markets act as cartels?
they act as cartels that police their boundaries and ensure that fair competition exists within those boundaries while eliminating competition from outside them. This is necessary because futures markets are a site of "free" competition, which is a carefully organized, artificial social arrangement; futures trading happens in open-outcry pits that look chaotic and self-organizing, so need strict rules (formal & informal) created and enforced by social relationships and organizational arrangements of power (cartel: group of producers who cooperate to restrict trade, often to fix prices, limit supply, etc.)
