Thursday, April 2, 2009

Could financial transparency have prevented the crisis?

The Wired article Road Map for Financial Recovery: Radical Transparency Now! suggests that it could. The argument appears to rest on two arguments:
1. Tagging with XBRL tags: ... if those mortgages and loans carried XBRL tags, and everybody who touched them along the way was required to use those tags as well, anyone would have been able to track their circuitous route through the financial industry and judge each CDO based on its actual content. They could have seen which loans were in default and which weren't, which CDO was overweight on Las Vegas real estate and which was in the relatively safe Louisville market. An amateur risk assessor could have separated the junk assets from those worth keeping and either bet against the companies holding the garbage, blogged about it, alerted the Feds—or all of the above.
2. Openness: ... LendingClub, a Web site that matches individual lenders with borrowers who need loans. Like other peer-to-peer lending companies, LendingClub asks borrowers to provide personal details—education, employment history, salary—and to write essays explaining why they want a loan and how they plan to pay it back. LendingClub runs its own credit checks, sorts borrowers by default risk, and comes up with interest rates. But LendingClub is unique in that it makes nearly all that information public (aside from data that could lead to privacy concerns), giving lenders the ability to sort through its database. It also tracks and publishes the history of every loan it helps broker.

Bartz downloaded the database of 4,600 loans—every essay, every neighborhood, every late payment—and started searching for patterns. He identified the 300 most common words in borrowers' essays and correlated them with payment histories. Sure enough, certain words seemed linked to late payments. Among the red flags: need, bills, and business. "Those were all words that reflected that the borrower might be in financial difficulty at the moment," Bartz says. Another one was also, which Bartz theorizes meant that the loan was being used for more than one purpose.

The main problem with any kind of reporting requirement is that those who have to report also have the incentive to manipulate the numbers. This lesson has been learned over and over again in Enron as well as other accounting scandals. It is the reporting requirment that led banks to move to so call special investment vehicles and off balance sheet items. Decades of FASB rules may have made accounting reports more streamlined but have hardly prevented any financial improprieties.

While it is likely that reporting requirements can decrease the instances of outright crime, the free market system and the spirit of capitalism survives so that for every rule that is made an anti-rule will be devised. While tagging may force companies to classify certain items with certain tags so that they can be tracked, it also provides the incentive for them to misclassify other items so that they cannot be tracked.

When we subject ourselves to scrutiny we inevitably affect our own behavior so that while under scrutiny we behave as we are expected but when wish to have some privacy we will build the blinds ourselves. Privacy concerns are enough for us to want to draw those blinds. A recent visit to Lending Club did not point to any open database for download. Surely, this is out of privacy concerns.

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