Computer Scientist Gets to the "Bottom" of Financial Scandal

Andrei Serjantov
Mon, 1 Apr 2002 11:06:26 +0100 (BST)

Here's an article in the Cambridge Evening News that might interest this
group ...

April 1, 2002.

Computer Scientist Gets to the "Bottom" of Financial Scandal

A Cambridge computer professor, Simon Peyton Jones, has made an
interesting discovery regarding the Enron collapse.  Enron, an
American energy company, started life as a regional natural gas
pipeline provider, the result of a merger between Houston Natural Gas
and InterNorth in 1985.  Its chairman, Kenneth Lay, eventually
transformed Enron into the world's largest energy trading company and
America's seventh-biggest corporation.  Enron filed for bankruptcy on
December 2 last year in the biggest collapse in American history.

Enron's collapse was due to a nearly impenetrable web of financial
contracts that disguised the true financial state of the company and
allowed Enron to report record profits while actually losing money.
A complex set of partnerships were set up in 1999 to move debt off its
balance sheet and hide losses.

The most complex of these financial contracts are derivative
instruments in which the value of a contract depends on other
financial contracts.  Accountants find that even when they are
scrupulously honest about the valuation of such contracts there can
still be sharp disagreements in regard to the worth of trading
reserves, debts, and other components.

Enter Professor Peyton Jones.  As part of his research at Microsoft in
Cambridge, he developed a computer language for describing and valuing
financial contracts.  With a colleagues Jean-Marc Eber and Julian
Seward, they developed a language capable of accurately describing and
valuing even the most complex financial instruments.  "While
accountants find financial derivatives to be mysterious and difficult,
for us they are just ordinary recursive  equations," says Jones.  "We
have been dealing with these for many years and have developed a wide
range of techniques for handling them."

This language is turning heads in the financial community.  According
to Emanuel Derman, managing director of firm-wide risk at Goldman
Sachs, "In all areas of computer science, there has been a natural
evolution towards building high-level languages with a syntax and
semantics specifically geared to the domain of the application.  Much
of the power of the Unix programming environment, as well as its
popularity among scientists and engineers, came from the pleasure of
working in this framework.  It makes sense to do the same thing in the
financial arena, and some of the tools we built at Goldman have
actually been small steps in this direction."

When Professor Jones heard about the Enron collapse, he decided to use his
new language to investigate.  After weeks of poring over financial
statements and contracts, he was able to create a set of mathematical
equations using his financial contract language.  Once everything was
ready, his team was ready to evaluate Enron's financial worth.

"It was very dramatic," he relates, "we were all gathered around my
computer and I hit the enter key.  Instead of generating a value, the
program returned `bottom'."  Bottom is a special value that computer
scientists use to denote a meaningless program.  Here, it indicated
that Enron had used financial contracts whose values did not actually
have any formal meaning."  He went on to explain how this works: "It's
really very simple.  If I write a contract that says it's value is
derived from a stock price and the worth of the stock depends solely on
the contract, we have bottom.  So in the end, Enron had created a
complicated series of contracts that ultimately had no value at all."

News of this discovery spread quickly.  While some accountants feel
that computers cannot replace human judgment in the interpretation of
financial contracts, others see this as just the first step in a trend
towards a more precise language of accounting and financial
contracts.  Nearly everyone in the accounting field agrees, however,
that this work by Peyton Jones will have a significant impact on the
legal case against Enron.

According to Peyton Jones, his success in the financial world comes
from years of research in Haskell, an esoteric computer language.
"Without the tools developed by the Haskell community I would never
have been able to do what I've done.  It's a jolly wonderful way to
program computers" he stated.

The Arthur Anderson accounting firm is rumored to have made overtures
to Peyton Jones.  A spokesman for Andersen's Cambridge office said it was
too early to speculate as to whether Peyton Jones might leave Microsoft
Research but he added "It would be a tremendous boost the credibility
of our company and the whole accounting profession to bring someone of
this caliber into our company."  But Professor Peyton Jones
plans to remain where he is.  "I'm flattered that my research has
finally been of use to someone but I'm quite happy working on Haskell.
Besides, I don't want to have to wear a suit to work every day."