Garbage In... Radical Transparency Out?

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.


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    Geoffrey Kidd (profile), Feb 24th, 2009 @ 3:07pm

    The brokers will hate it.

    Such a scheme would destroy their role as "information gatekeepers" to sucke... investors. When company data can be picked up and analyzed by anybody, it gets a lot harder to persuade people that "buy and hold" is a good strategy when you can get the information yourself and see that XYZMegacorp is headed into the swamp.

    OTOH, if a lot of different individuals can analyze the data, and publicly discuss why and what their different interpretations are, it's a lot likelier that somebody will be able to point out that XYZ has no clothes BEFORE the investors find themselves hip deep in alligators.

     

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    Ben, Feb 24th, 2009 @ 3:17pm

    Financial Engineer?

    Financial modeler != financial engineer.

    Wikipedia has a good definition of engineering. I don't think coming up with unreproducible and unreliable mathematical models is engineering. It's just playing with numbers until they get the results they want or they think they've got the right answer (that doesn't exist).

     

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      :Lobo Santo, Feb 24th, 2009 @ 4:52pm

      Re: Financial Engineer?

      "It's just playing with numbers until they get the results they want or they think they've got the right answer (that doesn't exist). "

      Absence of evidence is NOT evidence of absence.

      It likely exists... it may even be detailed in a small tattoo on your ass.

       

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      Anonymous Coward, Feb 24th, 2009 @ 6:23pm

      Re: Financial Engineer?

      Ben -> "I don't think coming up with unreproducible and unreliable mathematical models is engineering. It's just playing with numbers until they get the results they want"

      My thoughts exactly.
      There is nothing that even closely resembles Engineering in the works of those on Wallstreet.

       

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    Michael Long, Feb 24th, 2009 @ 3:20pm

    Devil

    "It would also serve to get rid of the extremely damaging focus on "quarterly" returns at the expense of long-term thinking. "

     

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    Michael Long, Feb 24th, 2009 @ 3:36pm

    Devil's advocate

    "It would also serve to get rid of the extremely damaging focus on "quarterly" returns at the expense of long-term thinking. "

    Would it? Or would the data be subject to DAILY analysis, magnifying the impact of each and every bump, turn, and hiccup? When would a three day downturn in sales suddenly become a self-fulfilling "trend"?

    Further, how would daily real-time access to the kind of data in a quarterly report have exposed the faulty thinking in a risk/reward model? In a sales projection? In R&D data? In resource planning?

    Finally, much of that data is considered proprietary, and is often quite expensive to develop and accumulate. Who would want to spend the time and money doing so, when their competitor's then get the benefits for free?

     

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      Mike (profile), Feb 24th, 2009 @ 3:44pm

      Re: Devil's advocate


      Would it? Or would the data be subject to DAILY analysis, magnifying the impact of each and every bump, turn, and hiccup? When would a three day downturn in sales suddenly become a self-fulfilling "trend"?


      That's possible, but highly unlikely. Right now, the stock market moves on rumor, rather than fact. Exposing all of the data would allow it to move on actual fact, and you get rid of the bogus rumor movements. It also doesn't carry a 3 month jolt as companies confirm or deny the rumors.

      Yes, there's a chance that some might react to the daily movements, but I doubt it. Most would recognize that the data is a flow and make overall decisions based on the data.

      Further, how would daily real-time access to the kind of data in a quarterly report have exposed the faulty thinking in a risk/reward model? In a sales projection? In R&D data? In resource planning?

      It's not just "the kind of data in a quarterly report." That's the point. Radical transparency would go much deeper. Read the article to see how it would work out. And, yes, it absolutely would have exposed the faulty thinking, because rather than relying on the output of the black box to determine the value of those financial products, others could craft their own models, and anyone could weigh in on the pros and cons of the model.

      Finally, much of that data is considered proprietary, and is often quite expensive to develop and accumulate. Who would want to spend the time and money doing so, when their competitor's then get the benefits for free?

      Again, if you get a competitive advantage (i.e., more people willing to invest in you) by being transparent, then it becomes worthwhile. Those who refuse to become radically transparent are automatically seen as much greater risks, and the cost of capital becomes much higher.

       

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      Michael, Feb 25th, 2009 @ 11:28pm

      Re: Devil's advocate

      I believe the transparency would be on the assets and liabilities and reporting basic statistics data. Data such as 'House in Zip+4 valued at $ (Year by firm) X year mortgage with average payment rate of Y in period Z.'

       

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    Anonymous Coward, Feb 24th, 2009 @ 3:52pm

    I have been thinking about this exact same idea too, but have never heard or read anything about it before (granted I don't go looking for it). This idea makes complete sense, although we all know that typically means that it won't ever happen...

     

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    Adam (profile), Feb 24th, 2009 @ 5:13pm

    Techdirt?

    Is this blog still called techdirt? or have we changered to "EconoDirt" in the last month and no one told me about it?

    don't get me wrong... i still like the content... just seems a little, mis-named, of late.


    (then again, i suppose over the years it could've had many names... )

     

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      Mike (profile), Feb 24th, 2009 @ 6:02pm

      Re: Techdirt?

      Is this blog still called techdirt? or have we changered to "EconoDirt" in the last month and no one told me about it?

      Hi Adam, we've always had business and economic news as well. From the beginning the blog has been focused on trends that *impact* the overall technology industry, and that includes the economy as well.

       

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    Lar, Feb 24th, 2009 @ 5:51pm

    Replacing quarterly b.s. with daily b.s....

    ...wouldn't help address the Enrons and Worldcoms out there. The real culprit is the complete lack of corporate governance. When a company is owned by a million day traders, the CEO answers to no one. Until that problem is addressed, the stock market remains a sucker's bet.

     

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      Mike (profile), Feb 24th, 2009 @ 6:14pm

      Re: Replacing quarterly b.s. with daily b.s....

      ...wouldn't help address the Enrons and Worldcoms out there.

      Actually, that's not true at all. With the *actual* data, traders could understand what both of those firms were actually doing. The problem with both was that they were hiding what they were doing. That's why it all came crashing down. If they were exposing the real underlying data, people would have recognized the issues much earlier.

       

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    Anonymous Coward, Feb 24th, 2009 @ 6:25pm

    Radical transparency will happen right after Congress starts reading legislation before passing it and Obama starts posting bills online for 5 days for public comment before signing them.

     

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    Anonymous Coward, Feb 24th, 2009 @ 6:42pm

    Good idea

    But sadly it'll be implemented the election after paying politicians is made illegal.

     

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    Joel, Feb 25th, 2009 @ 1:24am

    What's stopping them?

    Daniel had a very through and engagin article there. Mike, your summary was pretty impressive too.

    I wonder though, if there is a Federal or State law somewhere that says that companies, both public and private, can only release raw financial data at "quarterly" intervals? In other words, what's stopping Sprint (let's say) from taking the information that they release every quarter and updating it on a say weekly basis to shareholders and/or news outlets?

    Mike, if your theory that this will increase the value of an investment then wouldn't a company be willing to restructure their accounting to "invest" in the information? In addition, if you provided that information in the XBRL format wouldn't that increase the value of the investment even further?

    I understand that the major corporate companies will be unwilling to do anything unless mandated by the government by themselves unless it provides an immediate positive push from investors and consumers.

    Moving away from the corporate world to the financial world. If banks started this type of reporting (XBRL on a daily or even weekly) basis then wouldn't their underlying problems rise to the surface? Therefore, (let's take Citi) wouldn't the fact that their balance sheet is so cooked that I would bet their CEO doesn't know what it says, scare away the investors that they so desperately need right now to keep them even marginally afloat? If this happens what happens when Citi goes bankrupt? Is BOA next?

    I agree that transparency is the key but I guess my major concern about transparency now is that it will probably do what we don't want it to do with our 20 biggest banks - make them fail.

     

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      nasch, Feb 25th, 2009 @ 10:28am

      Re: What's stopping them?

      You're saying it's better to hide their deep and systemic problems? Would it really be better to have severely flawed banks sticking around, or allow them to fail and be replaced with transparent well-managed banks? Obviously the latter would cause some disruption, but it seems like it could be the better long-term solution.

       

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