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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Filed Under: financial crisis, radical transparency


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  1. icon
    Mike (profile), 24 Feb 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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