By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, June 15, 2010; A10

The next time the Securities and Exchange Commission stops a financial fraud, it might be partly because of work that physicist Gregg Berman did studying the tiny particles spun off by exploding stars and distant galaxies.

Today, the Princeton-trained nuclear physicist is investigating for the SEC what was behind the massive flash crash that sent the stock market into a tailspin last month. A specialist at culling conclusions from masses of chaotic information, Berman is in part trying to ascertain whether wrongdoing played a role.

Although lawyers fill most of the SEC's ranks, the agency has been hiring experts with specialized quantitative skills and those who have worked on Wall Street who are hip to its tricks.

The SEC, like many federal regulators, failed to anticipate the economic crisis, and postmortems have revealed that the agency badly needed people who could help it assess the complex markets that make up the modern financial system. What's more, under the landmark financial regulations pending in Congress, the SEC is set to inherit new powers to regulate financial instruments known as derivatives as well as hedge funds -- making it all the more urgent that the agency have the firepower to police those areas.

Among those who have gone to the SEC recently are a former managing director at defunct investment bank Salomon Brothers, a former senior derivatives trader at American International Group, the insurance giant bailed out by the federal government, and a veteran hedge fund lawyer.

For Berman, 43, his SEC job in many ways is a far cry from the late nights he spent conducting experiments at Princeton's particle accelerator in preparation for his doctoral thesis, "The Study of the Beta Decay Spectrum of Sulfur-35." But in other ways, it's not.

"Experimental physics is about drawing conclusions from very messy data," said Berman, who started doing financial analysis after receiving his PhD. "And finance and economics and the type of work within the division that I'm at at the SEC is about trying to draw conclusions and make recommendations based on lots of data, data from the marketplace that can be quite messy as well."

Before he turned his attention to last month's market crash, Berman was working in the agency's new Division of Risk, Strategy and Financial Innovation, which combines economic, computer, financial and legal analysis to uncover financial wrongdoing in complex and rapidly growing markets. The unit, established in the fall, is like an internal think tank that provides expertise to officials elsewhere at the SEC who are prosecuting cases and developing rules to regulate Wall Street.

Although the head of the division, Henry T.C. Hu, is a lawyer, his background as an academic makes him an unusual pick for a leadership post at the SEC. As a professor at the University of Texas law school, he has become an authority on emerging issues involving banks, derivatives and hedge funds.

Also playing a leading role in the new division is Rick Bookstaber, an economist trained at the Massachusetts Institute of Technology who was managing director for risk at Salomon Brothers and ran a hedge fund that traded on math-based strategies.

Long before he joined the SEC, he wrote a critically acclaimed book warning of looming dangers in the financial system and declaring that regulators needed to change how they work. Just days into the Obama administration, Bookstaber wrote on his blog that the standard government formulas for reviewing how financial companies operate must be reconceived: "[M]arching in with a subpoena in one hand and a sixty page questionnaire in the other is not the way forward."

"This job cannot be done by SEC lawyers or career government workers," he wrote. "We need to entice market professionals into government service who are on par with those in industry."

Although the SEC has been able to attract a few seasoned experts who could be making much more money in the private sector, it is having trouble filling out more of its ranks with people with unconventional résumés. The challenge, Bookstaber said, is in recruiting undergraduate computer science wizards who might otherwise work for Google or trade for hedge funds. "We have to rely on public spiritedness as opposed to dollars to pull them here."

Legislation pending in Congress would add to the SEC's limited powers to police derivatives, the multitrillion-dollar market of complex financial contracts, and hedge funds, the secretive investment firms.

Michael Fioribello, 38, might know more about derivatives than anyone else at the agency. Before going to the SEC, he worked at AIG for nearly a decade, helping to manage the company's derivatives operation, hedging the firm's risks by buying and selling financial contracts. He said he wasn't involved in AIG Financial Products, which insured the toxic investments that led to AIG's downfall.

The SEC oversees trading firms that set up the exchanges where some derivatives trade. It also investigates financial firms or individuals thought to be using derivatives in illegal ways, such as profiting from insider information. Fioribello said he has provided colleagues with insights into how financial players structure derivatives to conceal something that could be illegal.

"Derivatives often have many different parts, and some of those may not intuitively make sense. There can be bells and whistles done to reduce transparency or otherwise circumvent federal securities laws," he said. "I can say I've traded many particular products and know whether the price for the trade was right or the rationale for the derivative was right."

Fioribello's role stands to expand. Under the new legislation, large segments of the derivatives market would be subject to new oversight and standards, and the SEC would play a big role as regulator.

Likewise, the SEC would inherit new responsibilities to inspect hedge funds under the legislation, which requires them to register with the agency and be subject to examinations.

Norm Champ, 46, a new associate director for examinations for the agency, formerly helped manage a $7 billion hedge fund, where he often encountered SEC regulators who he says didn't know enough about how hedge funds work.

The SEC can investigate hedge funds suspected of having committed wrongdoing and receives information about them from regulated investment banks that do business with them. Some hedge funds also voluntarily register with the agency.

Champ has been advising colleagues who inspect hedge funds about the ways firms can skirt the law. For example, some hedge funds might value their assets more generously in the first three quarters, earning management fees on that performance, then mark the assets closer to what they're worth at the end of the year, when auditors take a closer look.

"When you're in the asset management business, you can see where the temptations and pitfalls may lie and where people may be tempted to cut corners," Champ said. "One of the things I mentioned when I interviewed here was that I know where some of those temptations lie, and I think I can help the exam team find those things."