WP 03: Conventions and the process of market formation: the case of the market for non-prime mortgage-based securities
The article develops the hypothesis that conventions can be key to the development of markets for previously untraded financial assets. It argues that the absence of historical data on the performance of assets may induce agents to form beliefs in ways that preclude the formation of markets for certain financial instruments. Conversely, in the absence of trading, the data on the basis of which agents could revise their beliefs will not be produced, giving rise to a feedback loop that hinders the process of market-formation. The article contends that one of the ways of overcoming this state is the development of conventions about the distribution of future payoffs. It then shows that the emergence of the conventions that credit rating agencies could reliably measure the riskiness of non-prime residential mortgage-securities (RMBSs), and that the FICO score could reliably give a quantitative expression of the creditworthiness of individual borrowers was a crucial enabling condition of the formation of a market for RMBSs in the United States.
Keywords: conventional valuation, probability, mortgage-backed securities, credit rating agencies, credit scores.
JEL codes: B29, G11, G12.