Less sophisticated mortgage traders reverse-engineered competitors’ models by observing their trades

Evidence

Meriwether’s group had been imitated even in its days at Salomon Brothers. In the market for mortgage-backed securities, a crucial issue, as noted above, is calculating the impact of homeowners’ “pre-payment” option. The calculation was a non-trivial modeling task that typically took the form of adjusting the “spread” of the yield of mortgage-backed bonds over the yield of Treasury bonds of similar maturities to take the pre-payment option into account. … “The people making more money,” he says, “were the ones with the better models, the Meriwethers of the world.” Those who were less sophisticated in their modeling learned from the Salomon group by what Roll calls “mimicry”: by inferring from Salomon’s trading the features its model must have. Roll puts it this way: “If you saw Meriwether going long [that is, buying a mortgage-backed bond] with an option-adjusted spread you thought was five basis points, you knew that his model said it’s 100 basis points.” In consequence, less experienced participants in the market would ask themselves what they would have to do to their pre-payment model to generate a larger spread, saying to themselves, in Roll’s words, “Let’s tinker with [the model] and see if we can get that.” — Donald MacKenzie, An Engine, Not a Camera, 1023

Categorization

• SHARE: The ‘tinker with the model to match a visible trade’ mechanism is a vivid nugget for anyone teaching market microstructure or performativity.
• XREF: connects to: Trading screens function as observatories permitting remote participation in market constitution — Karin Knorr Cetina & Urs Bruegger, Global Microstructures: The Virtual…, 85; A market model can shape markets actively rather than merely describing them — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1165; Imitation-based microstructure can defeat the risk reduction promised by diversification — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1089

Broader Connections

• A market model can shape markets actively rather than merely describing them #exemplifies (0.80) — Donald MacKenzie, An Engine, Not a Camera, 1165