Thursday, January 24, 2008
Yet again, newly created financial instruments designed to reduce risk actually increase it exponentially. Yet again, frauds and bubbles, formerly national in character, now impact markets around the world. And, yet again, an institution at the heart of investment activity and the provision of credit finds itself engaged in the virtual destruction of its capital that is normally made available for these purposes.
A brilliant young rogue trader, who spun an elaborate web of fake transactions from his desk, has cost France's second-biggest bank €4.9bn (£3.7bn) in what appears to be the largest-ever fraud by a single trader.
Société Générale was last night struggling to shore up confidence in the banking system after the huge fraud was conducted undetected by the junior trader at its headquarters.
Jerome Kerviel, 31, deemed "a genius of fraud" by France's top banker, caused five times the financial damage of the notorious rogue trader Nick Leeson, who sparked the collapse of Barings Bank in 1995 with losses of £800m.
The discovery at the weekend of what SocGen deemed an isolated fraud of "unprecedented size" caused concern in a market already reeling from the sub-prime crisis. There was astonishment at how a junior trader on the bank's award-winning derivatives desk, described as both "brilliantly intelligent" and a troubled Walter Mitty character, could create fictitious accounts and wreak havoc. The young trader appeared to have acted alone and reaped no personal financial benefit. "[It's] everyone's worst nightmare," said Richard Fuld, chairman of the rival bank Lehman Brothers at the World Economic Forum in Davos.
The City of London was yesterday awash with rumours that SocGen's desperate race to clear up the damage and unravel Kerviel's trading positions were at the heart of the stockmarket turmoil on Monday when share prices across Europe crumbled by 7%. Even the insistence of the French prime minister, François Fillon, that SocGen had "nothing to do with the situation on the financial markets" failed to stop the gossip.
SocGen insisted it would weather the storm and still post €800m profits for 2007. But news of the fraud could not have come at a worse time, with investor sentiment already fragile and confidence battered. "How will we [the market] ever get investor confidence back?" asked analysts at the investment bank Dresdner Kleinwort in a research note.
At SocGen's giant glass tower in the Parisian business district of La Défense, where Kerviel worked, the normally sedate corridors yesterday thronged with people in crisis management.
The trader, who joined the bank in 2000, aged 23, was extraordinarily sophisticated and technically proficient. In his first job, he started out developing the intricate computer systems used to control the positions that traders across the bank could take out in markets around the world. To try to control risks, it is now commonplace for each trader to be given a limit on the positions they can take. The SocGen computer was regarded as a hi-tech piece of kit, the best in the business for the best derivatives house around.
But Kerviel knew how to manipulate it. He was moved to a trading job in 2005 to work on a desk known as Delta One. Kerviel had a junior job as a hedger - essentially paid to reduce the bank's risk by taking out opposite positions to the ones being run by the traders. His salary was not in the stratosphere of high-flying City traders. He was on around €100,000. His personal trading limits would have been small, in the tens of millions of euros.
Around December, he seems to have removed all the limits on his personal trading positions and created fictitious customer accounts. Through December he seems to have taken out a series of short positions - essentially betting the markets would fall - and closed them all out so that by the end of the month he was flat. In January, though, he decided to do the opposite, buying the markets through futures contracts in the expectation that the markets would rise. They did anything but and he seems to been got caught out.
Kerviel was found out at the end of last week when one of his trading positions popped up on SocGen's internal system as being over his trading limits. He immediately confessed to senior executives.
The head of the investment banking arm Jean-Pierre Mustier, who interviewed him throughout Saturday, was said to have become increasingly concerned about him during the course of the day. Kerviel was said to be a Walter Mitty character and was provided with counsellors by the bank. "Sometimes people don't know the size of what they are getting into," Mustier said yesterday.
He apparently acted alone and did not personally make any money from his fictitious customer accounts. The bank said it was baffled as to his "irrational" motives. But there is a suggestion that he did it to prove the system could be broken. Michel Marchet of the French CGT banking union warned he may have been trying to get spectacular results to boost his bonus.
Kerviel seems to have believed he had uncovered a sophisticated new way to trade that would unleash huge profits for the bank. It appears he had been trading futures contracts on three major stockmarkets - the French CAC 40 index, Germany's Dax index, and on the EuroStoxx 50, comprising the biggest stock market-listed companies in the eurozone. The positions appear to have been for €1bn each. By the time they were assessed on Sunday night they were valued at €2bn. Kerviel is thought to have helped unravel them. The losses escalated as the stock markets fell.
SocGen's chief executive, Daniel Bouton, said the fraud was "very simple in its techniques but extremely sophisticated in his method of concealing it".
Can the Federal Reserve, the Bank of Japan and the European Central Bank drop enough money from helicopters to revive the credit markets and prevent a deflationary spiral? Will the President and Congress undertake meaningful action to stimulate the US economy so that it retains its ability to serve as a global engine of growth? So far, it doesn't look very promising, but, at least we will be getting some rebate checks in June or July.
Oh, did I forget to mention that the monoline insurers, the institutions that insure mortgage bonds, may need as much as 200 billion dollars to maintain their AAA ratings so that they can continue to insure bonds in the future while maintaining the value of the bonds that they have already insured? And, if they can't? Fewer and costlier home mortgages (and, necessarily, even more declines in home prices), with more banks and savings and loans in extremis, because someone has to take responsibility for all that bad paper backing those mortgage bonds if the monoline insurers are no longer able to do so. Day by day, the relentless destruction of capital and asset values proceeds, seemingly without restraint.