Garbage In… Radical Transparency Out?

The Market

from the one-hopes... dept

The latest edition of Wired Magazine has two articles that pick up on stuff we discussed last year. First up, was the question of how the various quants on Wall Street got so suckered into believing their risk models that didn’t take into account the idea that mortgage defaults weren’t necessarily independent events. The end result was garbage in, financial crisis out. However, Felix Salmon has a detailed look at the “garbage in” part of the equation. Apparently, much of it was based on widespread reliance on a formula by one financial engineer, who thought that you could price risk by finding correlations. While in retrospect this may look silly — it should have looked silly at the time as well. It made a huge incorrect assumption: that correlations were static instead of variable. But… once it went into the “black box” people simply accepted the output as gospel. This is an issue that comes up all too often. Even if people know that a computer model is “just a model,” it leads to situations where they just rely on the computer because the computer said so — not taking into account it’s obvious faults.

However, the good news is that, as a result of this mess, there may actually be some movement towards the solution a few of us have been suggesting for a while: radical transparency. Back in November, we suggested that public companies should be allowed to do away with quarterly reports in favor of real-time data dumps in standardized formats, that would allow anyone to build tools on top of the data to analyze it themselves. Rather than obscuring the real situation within companies, as is the case today, this would expose everything, and let anyone build tools to analyze the real underpinning fundamentals. It would also serve to get rid of the extremely damaging focus on “quarterly” returns at the expense of long-term thinking. And, finally, it would help combat the problem described above where everyone’s relying on a black box to pop out risk metrics. Yes, many might adopt the same formulas, but by exposing all of the underlying data in a real-time format with a full API, anyone could structure their own system for reading the data and analyzing it. Then we wouldn’t have silly situations where everyone believes that bundles of toxic mortgages have a AAA rating.

Of course, almost every discussion I’ve had with anyone about the subject had people saying the concept was so insane no one was actually thinking about it. Turns out that might not be entirely true. Daniel Roth discusses an almost identical plan in Wired, suggesting that the idea isn’t so far-fetched after all. That doesn’t mean anyone is going to implement such an idea any time soon, but at least the idea is out there and permeating and getting some attention. It may take a while, but eventually people will begin to realize that it makes much more sense than anything else going on these days. We’re not going to fix a broken Wall Street by throwing extra money at the problem, but we might be able to fix it by opening up, adopting radical transparency, and then letting the market more accurately value things based on real data.

Filed Under: financial crisis, radical transparency