appraisal auditing equity research credit ratings

Is Sunshine the Best Disinfectant for This?
fraud regulation

The Weak Underbelly of Capitalism

Want honest stock evaluations? Ready to try open source? The author is the founder of Public Sector Credit Solutions, where he uses open source tools to assess municipal and sovereign bonds. PSCS’s 2012 releases included the open source Public Sector Credit Framework and a free Sovereign Historical Fiscal Database. Previously, he was a Senior Director at Moody's Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

by Marc Joffe, 23 January 2013

Appraisal. 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 malinvestments that hinder growth and 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, the collapse of which still resonates.

These four services are so often compromised because of institutional factors. The people who conduct these types of analysis are rarely at the top of the food chain in the industries they serve. Thus they can be bullied or bribed by rainmakers at their firms or by clients to distort their findings. Also, while outright fudging of the numbers often occurs, the more widespread problem is selective use of facts to produce a suboptimal result in line with preconceived notions. The product is not an outright fraud, but it could be better. 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 very specialized and complex, rendering it difficult for individual regulators to spot inadequacies. 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 rapidly evolve 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 the source code for PSCF is posted on GitHub, a popular open source repository.

Just as 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.

JJS: It gives me hope when decent people come up with good ideas. Something like this new site should certainly help those with enough savings to invest. Something else that might help would be to totally transform the corporate charter so that it no longer shields naughty companies from punishment.

Perhaps even more fundamental would be to deprive businesses of any ill-gotten gains, and not just gains from theft or fraud but also the gains from owning or controlling land and natural resources. That flow of revenue is the great enabler of wrongdoing in the business world. Such revenue flows are common wealth so when they get misdirected into the wrong pockets, the whole economic system becomes corrupted.

Perhaps the Better Business Bureau would get behind geonomic policy and would de-tax earnings but recover the socially-generated value of land and resource.

BTW, if you have an article, especially a newsy one, please do submit it; thanks.

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Editor Jeffery J. Smith runs the Forum on Geonomics and helped prepare a course for the UN on geonomics. To take the “Land Rights” course, click here . 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.

Also see:

Fighting Back Against Poli-Econ Tyrants
http://www.progress.org/2012/deanbake.htm

How About Quantitative Easing For the People?
http://www.progress.org/2012/kaletsky.htm

Henry George, The First Progressive
http://www.progress.org/2012/heathjoe.htm

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