See a History of Rating.
It seems that current practice in trading securities is for the buyer to trust the seller as to the quality of the security. This has seemed to be a civilized thing to do when the seller was an investment bank that had been in business for 158 years. Current events suggest that buyers should look closer at such investments.
If there were more online transparency then it would be possible to drill down thru layers of financial indirection to the real fundament economic assets, like factories and houses, in order to sample and thus assess the real value of securities. Smart yet unsophisticated investors could then see an unbiased sample of their real or proposed investment. The current system is like buying a house without knowing whether it is built on sand.
This interesting article says that some hedge funds are much more transparent than others. It mentions without endorsing some reasons that fund managers give for secrecy.
That some hedge funds are more transparent allows the hope that if investors demand transparency the problem could be solved without government intervention, aside perhaps for establishing such a standard. (Not all standards are government sponsored.)
Designing sampling strategies is tricky but robust even in an adversarial context—the sampler wins, but it is not trivial. Some such strategies rely on the veracity but not the wisdom of the sampled institutions. The current flap is over unwise investments, not lies. More complex and expensive strategies detect some sorts of fraud. We need a conceptually simple technology to see into our investments.
I hear of European banks buying billion dollar instruments based ultimately on american mortgages. What if the purchasing agent had said to the seller:
Due to the complexity of today’s derivatives, this drilling process is slightly convoluted. If the expected value of some sub-asset were contingent on being insured, by some company, then the drilling would branch, on the flip of a biased coin, to the solvency of that company. In short ‘Follow the money stochastically.’, or better ‘Sample the assets stochastically.’. Even if current financial tools don’t understand common mode failures, the smart, yet unsophisticated investor will, even if he does not know it by name.
Designing a technology and industry of such evaluation remains to be done. It is vital for the institutional investor which may be able to perform it itself. It is important to make this available to the average investor. It will take time.
The credit agencies are laughable today. Their descent began with laws that predicated certain transactions on their reports. A monopoly, especially a legislated monopoly, is fatal.
Next, the game.
Multi dimensional risk I quote:
Taleb replied: “Altimeters have errors that are Gaussian. You can compensate. In the real world, the magnitude of errors is much less known.”