Wall Street meltdown linked to 'outsourcing' of regulation to private code

Computerworld - The full depth of IT's involvement in Wall Street's meltdown is unknown, but one plan to stop it from happening again calls upon a growing IT trend: open source.

Erik Gerding, an assistant professor of law at the University of New Mexico who researches securities law and asset price bubbles, said that in agreeing to rely on computer models, the U.S. Securities and Exchange Commission essentially "outsourced" the financial regulation to proprietary codes developed by financial services firms.

The fix? Open source the underlying codes -- much like with open-source software -- to improve the code used by financial services to calculate risk and boost transparency for regulators.

Risk models of financial services have thousands of variables and are as complicated as weather system models. They can take enormous computing power to run, which is evident in some of the spending by the industry. In 2003, financial services firms spent $169 million on high-performance systems. By 2007, research firm IDC said, spending reached $305 million.

As capability and power of the technology increased, so did the complexity of the investments, such as with mortgage securities. Regulator confidence increased in these tools so much so that the SEC made a fundamental change in how to regulate financial services. On April, 28, 2004, the SEC -- at the insistence of financial services firms -- loosened its capital rules, agreeing to rely on financial services' computer models in assessing risk. This meeting, which received scant attention at the time, was recently the focus of a New York Times report.

In a draft paper made available last month, Gerding said regulators may have been comfortable with this increased level of risk because they saw lenders on the hook for the loss. "Lenders and the financial markets, many regulators assumed, accurately priced and managed this risk due to advances in the risk models -- a type of code -- they employed," Gerding wrote.

The SEC was also acting at a time when confidence in technology was high. If there was any reason to be worried about the SEC's action, it wasn't evident in a speech Allan Greenspan, former chairman of the Federal Reserve, delivered in 2005. He said technology and new credit-scoring models gave lenders a means "for efficiently extending credit to a broader spectrum of consumers."

So, who comprised this "broader spectrum" of consumers? Subprime mortgage borrowers. "Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately," said Greenspan, who stepped down in 2006.