October 28, 2008

With each passing year, little children find themselves less impressed by those scary monsters all dressed up for Halloween. It's all part of growing up. But when grown-ups shrug their shoulders at real monsters, the implied defeatism is truly frightening. Yet how else to react to the news?

For instance take Brad Stone's report (*) on the winding down of "the Herbal King group" through legal pressure brought by the Federal Trade Commission. One spammer down and good riddance but Brad Stone is no dupe. He ends his story with this level-headed quote: "It wouldn't be a surprise if people don't notice any difference". Remember five years ago? They had already stopped the King of Spam (1).

Truth to tell, it is impossible to eradicate spam as long as it is legal for suppliers to harvest email addresses from powerless clients and jam their mailboxes with their unwelcome marketing messages. Enjoy life in New Orleans while the dams hold.

Were marketing the only villain when it comes to violating our eprivacy rights! Governments of course have a penchant for eavesdropping and their intelligence officers need to have some fun in order to relieve their boredom. Scott Shane warns us (**) phone calls by Americans stationed in Irak appear to be fair game. According to a whistle blower, "eavesdroppers would swap recordings of intimate calls for entertainment".

It not just for a bit of fun that employees with access to "'information' concerning the private lives of others" break their code of good conduct, whatever it happens to be. Some are naive enough to fall to pretexting and other confidence games. Others are quite ready to sell scoops, destroy reputations or blackmail their victims. Side effect of an official investigation into a "campaign to smear [him] before his election", "President Nicolas Sarkozy of France filed a legal complaint [...] against a former national intelligence chief", relays an AP bulletin (***).

This Halloween though, not all masks are recycled from years past. Check this new character, courtesy of Alan Beattie fresh from a congressional hearing during which "the chair of the House of Representatives oversight committee" complained "the [credit] ratings agencies broke [their] bond of trust" (****). In Moody's own CEO's words, "In some sectors, [the market] actually penalises quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating". More crudely put, the higher the ratings one gives, the higher the market share one gets.

Who has not heard about grade inflation in academia? This is how professors under competitive pressure buy popularity from complicit students to secure their teaching positions. The same wisdom had inspired Moody's and its competitors. Professors of course get their revenge whenever they are asked by a former student for a sealed recommendation. The problem with Moody's is that its rating was the total extent of its recommendation. Without trustworthy recommendations, truth on assets-backed securities has been drowned in lies to considerable damages to the economy.

We have long stressed how capital a role recommendation mechanisms play in today's Information Age (2). Perhaps we should look closer on what business models can sustain them without creating conflicts of interest.

In principle, there is nothing wrong in being paid for recommending a specific transaction if the reward depends on recommendation accuracy and waits till the factual truth is established, e.g. when the recommender insures the transaction. As long as entities which take recommendations have already decided to make a transaction, a recommender can also be paid a fixed amount per transaction. The danger here lies in relaxing any of these conditions. To increase revenues, interested recommenders may pressure people into making a transaction when their best interest is to make none. And if the unit award is not fixed, recommenders will bias their advice to favor the transactions which benefit them the most.

Ideally then recommenders should be disinterested as to whether a recommendation leads to a transaction or not. But then how to reward them? If a recommender has independent means, as do professors who recommend former students for a job, local bankers who act as a public notary for their clients or Google which ranks unpaid search results apart from paid ads, the reward is intangible. The recommender's reputation is enhanced by giving good recommendations. Whether the mechanism satisfies our criteria for decentralization, responsibility and process is not the point here.

Independent, disinterested recommenders may be too much of an ideal. Stock analysts were supposed to be independent till they were found to be rewarded for drumming up business for the investment banks they worked for. If the recommender has to be paid for giving advice then who should pay? The one who is recommended or the one to whom he is recommended? For Moody's CEO, "potential conflicts exist regardless of who pays."

I beg to disagree. Recommending him who pays you is to act as a sales channel and Moody's has proven to be as objective as a used car salesman. Recommenders paid by those who receive their recommendations have no such conflicts of interest. But they do have the problem of every digital content creator. How can they be paid more than once per rating when each such opinion is bound to be copied and republished for free? Mr Raymond McDaniel may well want to stick to his business model. Who would want to exchange one which is corrupt for one which is bankrupt?

For a solution remember recommendations ought to be but one dynamic factor in the value market approach I advocate. On such a market assume Moody's decides to rate a particular security. Let sellers find out and boast of their ratings. Buyers should know never to trust such facts unless they verify it at the recommender's according to the rule of three. What the recommender sells to the security buyer then is not the rating itself but the on the spot verification the security seller had not lied to get matched.

Beyond their conflicts of interest, the real issue with the top three rating agencies is their cosy oligopoly. The more dominant they are, the more their expert, yet fallible opinions become oracles, turn into self-fulfilling prophecies and end up acting as a bubble nursery. On value markets, buyers should not confuse advice with insurance and dispense with further analysis. But the US Treasury should also be well advised to break up this oligopoly and increase decentralization of the corresponding recommendation mechanism.

Come Halloween, I have been known to imagine the future. The present is frightening enough for those grown-ups who have the courage to face it.

Philippe Coueignoux

• (*) ....... Authorities Shut Down Spam Ring, by Brad Stone (The New York Times) - October 15, 2008
• (**) ..... Panel to Study Military Eavesdropping, by Scott Shane (The New York Times) - October 10, 2008
• (***) ... Sarkozy Accuses Ex-Spy Chief Of Violating His Privacy, Associated Press (The New York Times) - October 17, 2008
• (****) . Credit agencies 'broke bond of trust', by Alan Beattie (Financial Times) - October 23, 2008
• (1) for more information, see the case study for our lecture on Spamming
• (2) see "recommendation mechanisms" in the list of Major Themes of these fillips.