Zeroes are zeroes after all. SocGen trader, Jerome Kerviel is not an anomaly. He is part of a global financial system where in every day, an average trader is in his mid-to-late twenties, who runs trillions of dollars of global money. There are two very clear kinds of bankers today – one is the “old school” 70s banker who has absolutely no idea of credit derivatives and associated risks, and the other is the “new school” banker who comes fresh out of college and paid millions in bonuses for his performance. These “new” bankers are hungry, arrogant, basking in self-glory and foolish. Nothing in life can replace the experience of facing a bear market and a bull market.
“Old-school bankers” are terrified of this “new breed” of traders because they do not understand the equity derivatives, or the sub-prime and other trading mathematical models. SocGen is considered one of the best in the world in this sophisticated area because of the strong engineering background. The best trading gadgets and specialists are the French or the French of Algerian descent because of their intimidating knowledge of engineering where they apply mathematical expertise to create innovative models, which the “old-schoolers” find difficult to grasp. This is what happened with Barings Bank in 1995. Nick Leeson was untouchable at his desk. Last week I had dinner with a group of bankers. The average young trader was a 24-year old with $2 billion outstanding positions on sub-primes looking at how to settle. He had no idea. It is a typical story of a banker who leaves the capital of the bank in the hands of kids with great mathematical minds but no idea of a bear market. And they party hard, drive their Lamborghinis and Porsches, drink the best champagnes, and spend £15-20,000 on the table. They seem to be competing with the footballers in terms of spending money hedonistically. The old-schoolers, who are terrified of this unknown quantity, gained their experience and integrity in a proper learning curve, to become custodians of people’s money. But they seem to be all gone now.
The point is that the old guards have to stop this one-way reverence and make sure that the proprietary capital of the bank is safe-guarded. In SocGen and in Barings scandal, there are very sharp similarities. The CEO, who was older and had no idea of sophisticated modern trading, allowed the hungry young traders to do what they did because they are afraid to lose them to other banks who pursue these hotshots like sharks, so no question was ever asked. These arrogant youths are the children of a bull market, in the bear, they run for cover and become fallen angels or scapegoats.
The young bankers of today, like Kerviel, who can lose nearly €5 billion (US$7.3 billion) as loose change, prove one point to us: Zeroes are just zeroes; they don’t understand a hundred thousand, or a million, and not a billion. For them a loss is a loss; after five zeroes, the following trail of dots don’t matter. Here there were nearly 10 zeroes after 5! The amount of positions he was running was around €40 billion, according to market rumours. On Friday evening, just before global black Monday, one of the compliance officers of SocGen found a trade which required a margin from the counterparty. The counterparty was called who said that this particular trade did not exist. All hell broke loose at 5:00 in the afternoon.
It transpired that Jerome Kerviel was running a fictitious book with long positions on European indexes. There were no counter trades in these long stock positions settled in the books of SocGen; once you settle a trade, no liability arises. But Kerviel had worked in the back office for four years and had experience on the risk management system. He exploited that knowledge and was able to create his own fictitious book. But the point which arises is that every trade carried out on a trader’s computer goes into the bank’s hard disk and then to compliance. So the problem that begs the question is that SocGen, as a bank, says all its trades were matched properly and there was no exposure, then how is it possible that the compliance never got a confirmation from the counterparty? There are always two parties in a trade – the seller and the buyer. If he was the buyer of stocks in all European indexes, then he should have had a seller against a counterparty name. Did he create a fictitious counterparty too? It was not a mere million or €2 million but a whopping €40 billion-gross position in SocGen on Monday-Tuesday; the loss is around €5 billion. It is the mother of all losses in banking!
It is impossible to accept SocGen’s position at face value in that they did not have any inkling or indication until Friday afternoon that some of these runnings have parallel books with positions of such huge sums. It is not just about positions, but about the counterparty. In today’s world, where know-your-customer policies have some kind of biblical importance, how could a fictitious book be run with fictitious trades and a fictitious counterparty?
Since August 2007, there have been grim rumours about serious problems with “one of the French banks” without naming names. The irony is that one of the most prestigious risk magazines in the UK have given an award to SocGen in January as a bank with the best-managed risks that serves its clients’ interests in the best manner. As a tongue-in-cheek remark, I’d like to mention that whenever I meet serious bankers with their black-tie finery, shaking their heads in feigned modesty and accepting the accolades, I really wonder if they are aware of the fact that these awards are not being given away by Mr. Alan Greenspan, but by upcoming commerce-hungry news journalists who want to make a living by doling out these prizes and getting sponsorship and advertisement income for their journals.
Here another question comes into play: how many people are involved in this fraud? Is he a scapegoat? Analysis and forensic examination of the accounts will later indicate the truth as to why 6 of the seniors have left the same desk. It begs the question how a senior trader at his desk not be aware of €40 billion positions when Jerome was not even one of the stars of the bank; he was just an ordinary guy. Asset-backed securities, CDOs, derivatives, sub-prime loans, all these are very specialized fields. One error and you are down for the count. Markets are callous; they shoot first and ask questions later therefore we should be careful in what the media tells us.
A man who runs a €40 billion position on his desk, equal to the GDP of Bulgaria and Romania, or equal to 50% of Egypt’s annual budget, could he be sitting for normal hours at the bank? He should be working 24-hours-a-day. To settle and square these fictitious positions would require a huge amount of input. So who was the manpower behind them? People go on leave, take coffee breaks, go on business lunches or dinners. The rumours were flying in August, a summer month where most Frenchmen take their vacation, then you have the Christmas and New Year holidays and holidays in January and February. Was this man not taking any leave? There is no doubt that the responsibility clearly lies on the senior management of the bank. There should have been lock-stock-and-barrel firing of the Board. The onus lies on them. This young man lost 7 friends on his FaceBook within two hours of discovery of the fraud. He is on the run, although this is being denied. He had a 6-hour meeting with the seniors where he explained his position. There was no personal impropriety.
Lessons are to be learnt from this latest scandal. One is that the Fed would never give a cut of 75bps if they knew what SocGen was upto on Monday and Tuesday. They erroneously thought that the fall-outs in the markets was the result of continuing decline due to sub-prime woes and gave the cut so there would be a lot of liquidity in the market to come back up. That was a blessing in disguise and a silver lining in the dark clouds. But perhaps the Fed overplayed its hand and gave us an extra 25bps more than required. In a way, Kerviel was not responsible for just a €40 billion loss; on Monday, €800 billion was lost in global markets’ meltdown, as of today, all markets are back up to Friday levels. So the capital has shifted from the banks to SocGen who sold in panic as did other Asian banks to some hedge funds and investment banks.
I will not mention names but we all know who made the largest profits on the subprime. They made tremendous money out of the fallout. The other silver lining is that the world’s financial system was put to a an extreme test, four times its performance design, not unlike planes that are put to a design test, but it came out, unlike the LTCM 1998 crisis which in comparison to this Monday and Tuesday is like a midget crisis. The ability of the Central Banks and the Fed to build financial institutions of the world on a day like Tuesday is unbelievable. So who is the net loser or winner? Money, like matter, does not disappear if the economy stays on course. Some banks and hedge funds have made huge sums by being short and others have lost their shirts.
One can say anything they want. Out of this calamity, one thing is proven: that the world financial markets are insulated. When we talk about a bubble and within a week 100% of the capital is lost, and regained, you wonder what bubble. Within a day when €800 billion is lost, and the next day markets rally and trade instruments as if nothing has happened makes it clear that the global financial markets do not allow the bubble to be pricked. On Tuesday, anyone who was buying Dow at 11,500 when it was down, after the Fed cut, could not buy anymore because there was nothing left to sell. I checked that Goldman Sachs was trading at 7 times its earnings at 79. So there are no bubbles. Only acts of God and human tragedies like 911 can bring the markets down. Financial issues are no threat because liquidity can be created by the central banks.
As SocGen declares results where entire year’s profit is written off and they have gone for huge capital injection of €6 billion by the same banks who made billions in crisis from this bank, my advice is that times is of the essence and not on your side so keep a little liquidity, and to overcome any blip, make room for yourself. With the capital provided to SocGen by other banks, SocGen is a great buy at this level, so is Goldman Sachs – one is a victim of fear and the other king of opportunity. At the end of the day, capital shift of such magnitude is crown of the capitalist system. In this game of global finance, there are no victims and no winners.
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