ETech: I Just Don't Trust You: How the Tech Community Can Reinvent Risk Ratings

My favorite conference of the year, ETech kicked off its general sessions today and its looking as stimulating as ever! While the topics covered by the conference have become less hard-core geeky, they have become more green and more broad. Sustainable topics, the environment and becoming better global citizens are just a few of the topics that have been struck this morning. ETech continues to make me think, which is the primary reason I keep coming back for more.

The first session I’d like to share with you was Toby Segaran and Jesper Anderson’s “I Just Don’t Trust You: How the Tech Community Can Reinvent Risk Ratings” presentation. Toby and Jesper posited that the system for rating credit instruments is horribly broken. Right before Lehman Brothers crashed, Moody’s credit rating agency gave Lehman Brothers a AAA A2 credit rating. Moodys immediately down-rated Lehman Brothers after they crashed — a little too late! Jesper and Toby outlined four reasons why the current system fails to do its job:

  1. Payments create bad ratings. NRSROs (Nationally Recognized Statistical Rating Organization), like Moody’s, S&P and Fitch all take payments to rate a given financial instrument and this incentivizes these companies to create false ratings. The structural problems that allow these conflict of interest transactions to occur beget a host of moral failures. This behavior amounts to bribery that doesn’t send anyone to jail.
  2. Opacity creates bad ratings. Credit rating agencies enjoy patent-like protection in the US, but without the requirement of public disclosure. They can operate on whatever principles they choose, which leaves their rating system nearly meaningless. What does a AAA rating mean? The current system makes an AAA rating no more effective than a gold star that might be awarded in grade-school. A closed consensus model doesn’t explore alternative options and it gives to the question if the current risk models are suitable for doing their job.
  3. Lack of ecosystem create bad ratings. Today’s market ignores good predictions only to celebrate them after the fact when the market starts crashing. We need to incorporate changing knowledge of the market into the models and constantly evolve them. Creating an ecosystem that can review financial information in broad daylight and encourage a greater accountability will create a more robust and accurate credit rating system. Its important to remove the incentives for secrecy.
  4. Single source of information creates bad ratings. A single viewpoint of financial data is too narrow to do justice in the complex market of credit ratings. Any and all sources of information need to feed into the model for the greatest chance at success. The current model encourages blind thinking, when credit ratings should focus on analyzing as many sources of data as possible.
  5. With the problems defined, Toby and Jesper propose the following requirements for a new credit rating system:

    • Ratings need to be accessible. Credit ratings need to operate from an information commons. Debt is about trust — a Digg style system won’t work here.
    • Ratings need to be open. Everyone needs to be able to see the complete view of the landscape.
    • Ratings need to be diverse. Many people need to take part in credit rating. Any new system needs to be built as a Bazaar, not a Cathedral!
    • Ratings need to be transparent. Transparency is a vital component in a new system — opacity only hides the shady practices of incumbents and prevents the system from really working.

    And rather than ranting without substance, Jesper and Toby have been working on a new system at Freerisk.org that acts as a specialized front end to the FreeBase database. Based on Open Data principles, FreeBase contains public SEC records (among many other data portions, including the MusicBrainz data). FreeBase exposes the SEC records in RDF via a public API, which makes accessing SEC data much easier than before.

    Jesper and Toby invite the general public to come and take part in this nascent project — they hypothesize that by exposing the data to more people, anyone can create a risk calculator. And of course, if everyone tried to create a new risk calculator, we’re bound to find new models that work better than the current models that allows financial catastrophes to happen. They conclude: “With a little help, we believe that we can beat the NRSROs!”

    If the current financial crisis bothers you and you feel angry enough to help look for a solution, go visit freerisk.org. Thanks for the informative talk, Toby and Jesper!

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