A manifesto from Wired
On the morning of March 29, 1933, dozens of reporters filed into the Oval Office for a press conference with the new president. Franklin Roosevelt had taken office earlier that month amid the greatest economic crisis the US had seen: 5,700 banks had failed, 25 percent of the country was unemployed, and more than half of all mortgages were in default.
Hope for a recovery was dim; the public had lost faith in the entire financial system. The number of American investors had exploded, from a few hundred thousand before 1916 to more than 16 million. Yet few of them understood the investments they held, many of which had proven to be junk. Supposedly sound companies were exposed as pyramid schemes. Of the $50 billion in securities sold in the previous decade, half had become worthless.
And yet, as reporters huddled around his desk, Roosevelt sounded confident. "I have something on the Securities Bill today," he announced. That day, members of his brain trust were on Capitol Hill, submitting a plan that would spark the creation of the Securities and Exchange Commission. One overriding concept lay at the center of the legislation: transparency. Louis Brandeis, before becoming a Supreme Court justice, had written an exposé of the financial system for Harper's Weekly, and one passage in particular had lodged in Roosevelt's brain: "Sunlight is said to be the best of disinfectants. Electric lights the most efficient policeman." The proposed bill would require, for the first time, companies to file detailed accounts of their financial health and activity, and bankers would have to report their fees and commissions. As Roosevelt explained it to the reporters around him, the bill "applies the new doctrine of caveat vendor in place of the old doctrine of caveat emptor. In other words, 'Let the seller beware as well as the buyer.' In other words, there is a definite, positive burden on the seller for the first time to tell the truth."
Now, here we are again, 76 years later, facing another crisis of trust that threatens the entire financial system. This time, the issue is no longer a lack of transparency. Since the 1933 Securities Bill, corporate America has been required to disclose a deluge of information in a multitude of ways--10-Ks and 10-Qs, earnings calls and Sarbanes-Oxley-mandated 404s. Between 1996 and 2005 alone, the federal government issued more than 30 major rules requiring new financial disclosure protocols, and the data has piled up. The SEC's public document database, Edgar, now catalogs 200 gigabytes of filings each year--roughly 15 million pages of text--up from 35 gigabytes a decade ago.
But the volume of data obscures more than it reveals; financial reporting has become so transparent as to be invisible. Answering what should be simple questions--how secure is my cash account? How much of my bank's capital is tied up in risky debt obligations?--often seems to require a legal degree, as well as countless hours to dig through thousands of pages of documents. Undoubtedly, the warning signs of our current crisis--and the next one!--lie somewhere in all those filings, but good luck finding them.
Even the regulators can't keep up. A Senate study in 2002 found that the SEC had managed to fully review just 16 percent of the nearly 15,000 annual reports that companies submitted in the previous fiscal year; the recently disgraced Enron hadn't been reviewed in a decade. We shouldn't be surprised. While the SEC is staffed by a relatively small group of poorly compensated financial cops, Wall Street bankers get paid millions to create new and ever more complicated investment products. By the time regulators get a handle on one investment class, a slew of new ones have been created. "This is a cycle that goes on and on--and will continue to get repeated," says Peter Wysocki, a professor at the MIT Sloan School of Management. "You can't just make new regulations about the next innovation in financial misreporting."
That's why it's not enough to simply give the SEC--or any of its sister regulators--more authority; we need to rethink our entire philosophy of regulation. Instead of assigning oversight responsibility to a finite group of bureaucrats, we should enable every investor to act as a citizen-regulator. We should tap into the massive parallel processing power of people around the world by giving everyone the tools to track, analyze, and publicize financial machinations. The result would be a wave of decentralized innovation that can keep pace with Wall Street and allow the market to regulate itself--naturally punishing companies and investments that don't measure up--more efficiently than the regulators ever could.
The revolution will be powered by data, which should be unshackled from the pages of regulatory filings and made more flexible and useful. We must require public companies and all financial firms to report more granular data online--and in real time, not just quarterly--uniformly tagged and exportable into any spreadsheet, database, widget, or Web page. The era of sunlight has to give way to the era of pixelization; only when we give everyone the tools to see each point of data will the picture become clear. Just as epidemiologists crunch massive data sets to predict disease outbreaks, so will investors parse the trove of publicly available financial information to foresee the next economic disasters and opportunities.
The time to act is now. An exhaustive study by the Transparency Policy Project at Harvard University's John F. Kennedy School of Government--analyzing disclosure rules for everything from restaurant cleanliness to SUV rollover risk--found that there's a very brief window after any calamity for government to institute changes. (Wait too long and the special interests start regaining their confidence and pushing back.) In the financial world, the old order is still trying to find its new shape. So the window is, briefly, cracked. Caveat vendor.
Philip Moyer, CEO of Edgar Online, walks into his conference room in midtown Manhattan a half hour late, clutching an inch-thick stack of copy paper. He's a broad-shouldered guy with dark brown hair pushed back from his forehead, as if a fan is constantly blowing directly onto his face. He slams the paper down theatrically: "One reason I'm a little bit delayed is that I started printing out a Bear Stearns free writing prospectus," he says. "The assets cover 462 pages. I got about 70 pages through."
Every bank that issues mortgage-backed securities--pools of home loans packaged together and sold as a single entity--is required to file a free writing prospectus, which lists every individual mortgage in each pool. An FWP contains endless columns of pure data, most of which don't even track from page to page. And each FWP is different: The banks have no uniform information that they're required to present in their filing. Even when they do report the same data, they do so using entirely different language. And yet somewhere among all this impenetrable code lie the bugs that destroyed the American economy.
Moyer discovered this in the spring of 2007, when two hedge fund managers independently asked for his help in making sense of some major banks' FWPs. Poring through all that paperwork by hand would take countless hours, and they wanted Moyer to extract and package the data in a way they could easily understand. Moyer, a former Microsoft executive, assigned four engineers to categorize and standardize the FWPs' contents--creating a Rosetta stone that could translate the 600 unique, inconsistent fields into 100 uniform categories. Three months later, he started delivering spreadsheets that clearly spelled out the risks in each of the pools, giving the financiers the ability to evaluate every aspect of the loans: location, proof of income, interest rate, appraisal value, and so on. They could drill down and compare the FWPs in a way that would have been nearly impossible before. And what they saw was a nationwide crisis in the making--as adjustable-rate mortgage rates ballooned, countless home-owners would default on their loans, rending the securities built on them worthless.
Of course, the hedge-funders didn't publicize their findings; they were seeking an informational edge. But imagine if everyone had access to the same data-crunching tools: Risky mortgage-backed securities would have been exposed, and banks, anxious to protect their reputations, would have stopped offering them. With complete information--including much more frequent posting of loan status--the market would likely have self-regulated as risk-fearing investors fled from companies holding or issuing the risky securities.
That's the kind of scenario that has kept Charlie Hoffman motivated for the past decade. A 50-year-old accountant from Tacoma, Washington, Hoffman is the originator of XBRL, a set of tags that standardizes financial information. Hoffman stumbled on the idea while trying to figure out a way to automate the tedious auditing process. ("Basically, I'm lazy," he says.) But while Moyer's team was forced to create complicated algorithms to codify kludgy financial documents after they were filed, Hoffman is agitating for companies to file their data in a standardized format from the very start. Today, nearly 50 companies report their information in XBRL to the SEC, but Hoffman says the protocol's real power will be realized only when every company starts using it--to keep track of their own operations as well as to report their numbers to investors and regulators. If all businesses are required to tag their every move, from each iPhone sold by Apple to every interest payment made by Exxon, they won't be able to engage in the kind of balance-sheet chicanery that kept Enron's investors in the dark. "Financial reporting should work the way that an iPod works," Hoffman says. "It should just be elegant and simple."
A few years ago, when banking regulators started requiring filings in XBRL from its member banks, it found that the time it took auditors to review a bank's quarterly financial information dropped from about 70 days to two. More regulators are catching on: Last December, the SEC announced that by June, every company with a market capitalization over $5 billion will be required to submit all filings using the format. And all publicly traded companies and mutual funds must follow suit by 2011. The result, Hoffman says, is that every investor will soon have the same ability as Moyer's hedge fund managers to export, manipulate, and mash up financial data. "Look how blogs changed news reporting," he says. "Anybody is a reporter. With XBRL, anyone can be an analyst."
A Wired Manifesto
Create an army of citizen-regulators