Saturday, January 26, 2013

The Weak Underbelly of Capitalism

Appraisals. Auditing. Equity Research. Credit Ratings.

These four seemingly unrelated disciplines serve a common purpose. They inform investors about the value and risk of potential investments. If executed well, these services ensure that capital is invested wisely and in a way that promotes economic growth. If executed poorly, these services produce inefficiencies that hinder growth and, at worst, trigger recessions.

Headlines from the last two decades provide us with ample reason to believe that these services are not always performed well. Shoddy audits of Enron were a major enabler of that company’s massive fraud. The internet bubble was abetted by compromised research issued by analysts receiving a share of underwriting fees. Exaggerated appraisals and lenient credit ratings created the subprime bubble and heightened the magnitude of the reversal in home prices - the collapse of which still resonates.

The problem is that these four (supposedly independent) “gate-keepers” are often compromised by business considerations. The people who conduct these types of analysis are rarely at the top of the food chain in the industries they serve. They can be bullied or bribed by rainmakers at their firms or by clients to distort their findings. While outright fudging of the numbers often occurs, the more widespread problem is the selective use of “facts” to produce a desired result in line with preconceived notions. The product may not be an obvious, outright fraud, but even if it’s not, it is often harmful. Fraudulent and incomplete analysis causes the ongoing misappropriation of trillions of dollars of savings. One might call this situation “the weak underbelly of capitalism” – if you are willing to apply the term “capitalism” to today’s economic system.

The problem of biased, inadequate analysis is difficult to address through regulation alone. Even the best regulators can’t be in the room every time an analyst is encouraged to “massage” his or her findings. Much of the analysis is specialized and complex, rendering it difficult for individual regulators to identify shortcomings. Further, like analysts themselves, regulators are also not at the top of the financial industry food chain. Since both analyzing and regulating don’t offer the maximal compensation afforded by managing and rainmaking, members of the first two groups are often outsmarted or manipulated by those in the latter two groups.

Although these four services are products of the market, they can nonetheless be healed through market processes. How? It is often said that “sunshine is the best disinfectant.” In the financial industry, intermediaries maintain their margins by keeping information to themselves. But if more eyes are available to review any given analysis, the biases and distortions affecting this analysis are more likely to be identified and fixed. Further, best practice in each analysis profession can evolve rapidly through peer review, just as the highest visibility Wikipedia articles evolve rapidly toward accuracy and completeness.

The internet, and the Wikis and open source projects it nurtures, can provide the remedy to the “weak underbelly of capitalism” identified here. By making analyses public, and thus subject to widespread review, discussion and editing, these work products can converge toward an optimum.

This outlook motivated me to create an open source government bond assessment tool, the Public Sector Credit Framework (PSCF). This framework enables a user to build a multi-year budget simulation for any government and to use the results to estimate a default probability as well as an implied rating for that government. All source code for PSCF is posted on GitHub, a popular open source repository.

While I was getting started on this project, I learned about a parallel effort launched by a Swiss-based mathematician named Dorian Credé. His web site, Wikirating, directly applies Wiki technology to assessing a broad range of credit instruments. In November, Dorian and I announced a content sharing partnership. Maybe this can be the beginning of a network of mass collaboration efforts focused on improving the quality of credit ratings. And, perhaps, lessons learned in these endeavors can be applied to the other disciplines that inform investors.

Credit ratings, appraising, auditing and securities analysis are all important functions that need reform. Rather than seek top down solutions to improve these services – solutions which often come with adverse unintended consequences – let’s use the organizing power of the internet to find voluntary, collaborative alternatives.

We welcome any responses, and look forward to working with any academics or market participants out there who share a similar interest in creating an alternative, transparent framework that supports investment analysis.

An earlier version of this post appeared on The Progress Report.

1 comment:


A large part of the financial panic of 2008 and 2009 was caused in large part to the false ratings on mortgage backed securities. This was a major cause of the financial crisis. When the bond of trust is broken and no longer their in the eyes of the investor. Than what is their left to instill confidence.