I’m sure most of you are familiar with the concept of the “Butterfly Effect“, that part of Chaos theory that tells us that the small disturbances of the air by a butterfly’s wings in Cleveland can cause a natural disaster on the far side of the world.

A popular myth is that the term ‘bug’ as applied to software glitches was coined by Admiral Grace Hopper after moths (and perhaps butterflies) were removed from the machinery of a Mark II Univac computer which had stopped working.

These two tidbits are related by a recent story in the Financial Times about how ‘coding errors’ (bugs) in computer models has resulted in a debt rating agency having to acknowledge they’d ranked investment vehicles wrongly and as a result increased the risk exposure of investors in those funds.

From the FT:

Moody’s is moving to re-examine the accuracy of all its computer models and place them under a centralised monitoring system after it formally acknowledged earlier this week that a glitch had appeared in one such mathematical model used to rate complex products.

Later in the article:

The moves come after the agency admitted on Tuesday that a “coding bug” had led the agency to incorrectly award top notch triple-A ratings to about $1bn of complex instruments known as constant proportion debt obligations (CPDOs) in 2006. This bug was first revealed in an FT investigation in May.

So, the bugs were found by a newspaper investigation in May 2008.. embarassing. The bugs affected the ratings applied to these CPDOs, and may have distorted the investment strategies of institutional investors. The Financial Times article in May tells us that:

The products were designed for institutional investors. In the recent credit market turmoil, those who still hold the products will have suffered some paper losses while others who have bailed out have lost up to 60 per cent of their investment.

Sheesh… up to 60% losses on investments. And it hit the papers.

The FT (28th April 2008) reports that Ratings agencies are coming under increased pressure to assure the quality of the information used in assigning credit ratings. Ratings agencies are reported to have told Regulators that:

Guaranteeing the quality of information used to assign credit ratings on structured finance securities would be “overly burdensome and redundant”

However, the burden and cost of avoiding bugs in software, processes and controls that impact on the quality of key information used in the Financial markets should be weighed against the risk of financial ‘natural disasters’ where decisions are made on foot of inaccurate information.

[Update] It would seem that the SEC and the European Commission (the civil service of the EU)  are intending to take action to regulate and regularise the dealings of these ratings agencies…[/Update]