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L’Affaire Kerviel: the mystery persists

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Recent reports note that Kerviel was up over a billion Euros at the end of 2007. It is impossible for him to have made such a large profit without exceeding his limits, so if his superiors knew about his profits they should have known something fishy was going on. It has been reported that Kerviel asked for a 600k Euro bonus in 2007. To justify this bonus he must have pointed to significant trading profits. Things don’t quite add up…

WSJ:

Sharing the blame: “I cannot believe that my superiors did not realize the amount I was risking. It is impossible to generate such profit with small positions. That’s what leads me to say that while I was positive [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading. A trader can’t generate so much cash on a daily basis with standard activities.”

On his bonus targets: “For 2007, I tried to negotiate a bonus of €600,000.” He added that a supervisor “led me to understand that I couldn’t hope for more than €300,000.” (Mr. Kerviel’s lawyer said her client hadn’t been paid any bonus.)

More background on elitism at Societe Generale:

WSJ: Kerviel Felt Out of His League

January 31, 2008; Page C1

In 2005, Jérôme Kerviel got the biggest break of his career: a promotion out of Société Générale SA’s lowly back office — a place so uncool it was dubbed “the mine” — and into a coveted job as a trader at the powerful bank.

But if clawing your way up from the mailroom wins you a badge of honor in the U.S., not so within in the rigid class system that defines the upper ranks of French finance. Mr. Kerviel’s effort to impress his colleagues now appears to be a motivating factor behind his disastrous trading spree, which burned a €4.9 billion ($7.3 billion) hole in Société Générale’s books.

“I was held in lower regard than the others because of my educational and professional background.” Mr. Kerviel told prosecutors over the weekend. His comments were from a transcript and confirmed by prosecutors and his lawyer.

Trading might not be rocket science, but Société Générale has a tradition of drawing its star traders from France’s most elite schools. Many have doctorates in disciplines such as astrophysics or nuclear science. They are known as “quants” for the complex “quantitative” mathematical trading formulas they develop. They pull down the biggest paychecks.

The bank’s top brass, including investment-banking head Jean-Pierre Mustier, is from the engineering school Polytechnique, the M.I.T. of France. Chief Executive Daniel Bouton graduated from the prestigious Ecole Nationale d’Administration, a school known for churning out high-level government functionaries that run the country.

“If you graduated from ENA or Polytechnique, you have an absolute tenure; if not, you miss out on all the good job opportunities,” according to a former Société Générale executive. “This rift exists all over the bank.”

French authorities placed Mr. Kerviel under formal investigation Monday on charges of forgery, breach of trust and breaking into computer systems. He was released but barred from leaving the country. Société Générale has accused him of fraudulent trading that at one point left the bank exposed by €50 billion.

“His career path made him sort of an exception,” says Mr. Mustier.

It hasn’t always been this way. Société Générale’s current corporate culture is a byproduct of the bank’s transformation in the late 1980s from a conventional retail bank to a major player on the global financial stage, according to Michel Marchet, a representative of one of the bank’s labor unions and 40-year employee. When he started, Mr. Marchet recalls, even employees without college degrees could build successful careers.

Suddenly, they found themselves overshadowed by new recruits plucked from France’s top-notch schools. The rise of a new “elite” class, Mr. Marchet says, also meant “fewer working-class people were joining the bank.”

The high-pressure atmosphere has taken its share of victims. In June, a trader in his 30s who worked on the same floor as Mr. Kerviel jumped to his death from a footbridge near Société Générale’s towering headquarters in the La Défense suburb of Paris. Moments before his death, Mr. Marchet says, a supervisor had interrogated the trader for losing about €9 million in unauthorized trades. “He took his bag, left Société Générale and jumped off a bridge,” Mr. Marchet says.

A spokeswoman at Société Générale declined to comment on social tensions at the bank. She confirmed that an employee committed suicide last year.

That death came in the wake of two other suicides in recent years. In 2005, a trader jumped to his death from a ninth-floor window at the bank’s headquarters, Mr. Marchet said. A year later, a back-office employee jumped in front of a train commuting between La Défense and the center of Paris.

The trading desk where Mr. Kerviel landed, the “Delta One” unit, deals with trades aimed at making small profits with stock-market fluctuations. Mr. Kerviel, who hails from a small town in Brittany and graduated from a little-known university, suggested in his statement to prosecutors that he hoped to curry favor with people who counted.

Mr. Kerviel’s job was to invest by simultaneously taking opposite bets on the direction of the markets. The bets were supposed to mostly offset each other in what is typically a low-risk way to make a small profit. But starting in November 2005, Mr. Kerviel started placing bets only in one direction, hoping for far bigger gains.

To hide his strategy, he created a set of parallel fake bets in the other direction to give his supervisors the illusion that his books were correctly balanced.

When his supervisors asked him about unusual transactions, Mr. Kerviel would rely on simple tricks to evade their inquiries. “I fabricated a fake mail using a feature in our in-house messaging system, a function which allows you to reuse the electronic letterhead I had received and change the body of the text,” he said.

At first, Mr. Kerviel’s strategy paid off — too well, in fact. His gains snowballed so quickly that, at some point, he had locked in a gain of €1.6 billion, about a third of the bank’s overall net profit in 2006.

At that moment, “I don’t know what to do,” Mr. Kerviel told investigators. “I am happy, proud, but I don’t know how to justify my gains.”

What seemed to disappoint Mr. Kerviel was that his trading prowess wasn’t being acknowledged. He told prosecutors that he believes managers were aware of his methods but never spoke up as long as things were going well.

“I cannot believe that my superiors did not realize the amount I was risking,” he said in the interrogation. “It is impossible to generate such profit with small positions. That’s what leads me to say that while I was [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading.

Written by infoproc

January 31, 2008 at 4:53 pm

L’Affaire Kerviel: the mystery persists

with 2 comments

Recent reports note that Kerviel was up over a billion Euros at the end of 2007. It is impossible for him to have made such a large profit without exceeding his limits, so if his superiors knew about his profits they should have known something fishy was going on. It has been reported that Kerviel asked for a 600k Euro bonus in 2007. To justify this bonus he must have pointed to significant trading profits. Things don’t quite add up…

WSJ:

Sharing the blame: “I cannot believe that my superiors did not realize the amount I was risking. It is impossible to generate such profit with small positions. That’s what leads me to say that while I was positive [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading. A trader can’t generate so much cash on a daily basis with standard activities.”

On his bonus targets: “For 2007, I tried to negotiate a bonus of €600,000.” He added that a supervisor “led me to understand that I couldn’t hope for more than €300,000.” (Mr. Kerviel’s lawyer said her client hadn’t been paid any bonus.)

More background on elitism at Societe Generale:

WSJ: Kerviel Felt Out of His League

January 31, 2008; Page C1

In 2005, Jérôme Kerviel got the biggest break of his career: a promotion out of Société Générale SA’s lowly back office — a place so uncool it was dubbed “the mine” — and into a coveted job as a trader at the powerful bank.

But if clawing your way up from the mailroom wins you a badge of honor in the U.S., not so within in the rigid class system that defines the upper ranks of French finance. Mr. Kerviel’s effort to impress his colleagues now appears to be a motivating factor behind his disastrous trading spree, which burned a €4.9 billion ($7.3 billion) hole in Société Générale’s books.

“I was held in lower regard than the others because of my educational and professional background.” Mr. Kerviel told prosecutors over the weekend. His comments were from a transcript and confirmed by prosecutors and his lawyer.

Trading might not be rocket science, but Société Générale has a tradition of drawing its star traders from France’s most elite schools. Many have doctorates in disciplines such as astrophysics or nuclear science. They are known as “quants” for the complex “quantitative” mathematical trading formulas they develop. They pull down the biggest paychecks.

The bank’s top brass, including investment-banking head Jean-Pierre Mustier, is from the engineering school Polytechnique, the M.I.T. of France. Chief Executive Daniel Bouton graduated from the prestigious Ecole Nationale d’Administration, a school known for churning out high-level government functionaries that run the country.

“If you graduated from ENA or Polytechnique, you have an absolute tenure; if not, you miss out on all the good job opportunities,” according to a former Société Générale executive. “This rift exists all over the bank.”

French authorities placed Mr. Kerviel under formal investigation Monday on charges of forgery, breach of trust and breaking into computer systems. He was released but barred from leaving the country. Société Générale has accused him of fraudulent trading that at one point left the bank exposed by €50 billion.

“His career path made him sort of an exception,” says Mr. Mustier.

It hasn’t always been this way. Société Générale’s current corporate culture is a byproduct of the bank’s transformation in the late 1980s from a conventional retail bank to a major player on the global financial stage, according to Michel Marchet, a representative of one of the bank’s labor unions and 40-year employee. When he started, Mr. Marchet recalls, even employees without college degrees could build successful careers.

Suddenly, they found themselves overshadowed by new recruits plucked from France’s top-notch schools. The rise of a new “elite” class, Mr. Marchet says, also meant “fewer working-class people were joining the bank.”

The high-pressure atmosphere has taken its share of victims. In June, a trader in his 30s who worked on the same floor as Mr. Kerviel jumped to his death from a footbridge near Société Générale’s towering headquarters in the La Défense suburb of Paris. Moments before his death, Mr. Marchet says, a supervisor had interrogated the trader for losing about €9 million in unauthorized trades. “He took his bag, left Société Générale and jumped off a bridge,” Mr. Marchet says.

A spokeswoman at Société Générale declined to comment on social tensions at the bank. She confirmed that an employee committed suicide last year.

That death came in the wake of two other suicides in recent years. In 2005, a trader jumped to his death from a ninth-floor window at the bank’s headquarters, Mr. Marchet said. A year later, a back-office employee jumped in front of a train commuting between La Défense and the center of Paris.

The trading desk where Mr. Kerviel landed, the “Delta One” unit, deals with trades aimed at making small profits with stock-market fluctuations. Mr. Kerviel, who hails from a small town in Brittany and graduated from a little-known university, suggested in his statement to prosecutors that he hoped to curry favor with people who counted.

Mr. Kerviel’s job was to invest by simultaneously taking opposite bets on the direction of the markets. The bets were supposed to mostly offset each other in what is typically a low-risk way to make a small profit. But starting in November 2005, Mr. Kerviel started placing bets only in one direction, hoping for far bigger gains.

To hide his strategy, he created a set of parallel fake bets in the other direction to give his supervisors the illusion that his books were correctly balanced.

When his supervisors asked him about unusual transactions, Mr. Kerviel would rely on simple tricks to evade their inquiries. “I fabricated a fake mail using a feature in our in-house messaging system, a function which allows you to reuse the electronic letterhead I had received and change the body of the text,” he said.

At first, Mr. Kerviel’s strategy paid off — too well, in fact. His gains snowballed so quickly that, at some point, he had locked in a gain of €1.6 billion, about a third of the bank’s overall net profit in 2006.

At that moment, “I don’t know what to do,” Mr. Kerviel told investigators. “I am happy, proud, but I don’t know how to justify my gains.”

What seemed to disappoint Mr. Kerviel was that his trading prowess wasn’t being acknowledged. He told prosecutors that he believes managers were aware of his methods but never spoke up as long as things were going well.

“I cannot believe that my superiors did not realize the amount I was risking,” he said in the interrogation. “It is impossible to generate such profit with small positions. That’s what leads me to say that while I was [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading.

Written by infoproc

January 31, 2008 at 4:53 pm

L’Affaire Kerviel: the mystery persists

leave a comment »

Recent reports note that Kerviel was up over a billion Euros at the end of 2007. It is impossible for him to have made such a large profit without exceeding his limits, so if his superiors knew about his profits they should have known something fishy was going on. It has been reported that Kerviel asked for a 600k Euro bonus in 2007. To justify this bonus he must have pointed to significant trading profits. Things don’t quite add up…

WSJ:

Sharing the blame: “I cannot believe that my superiors did not realize the amount I was risking. It is impossible to generate such profit with small positions. That’s what leads me to say that while I was positive [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading. A trader can’t generate so much cash on a daily basis with standard activities.”

On his bonus targets: “For 2007, I tried to negotiate a bonus of €600,000.” He added that a supervisor “led me to understand that I couldn’t hope for more than €300,000.” (Mr. Kerviel’s lawyer said her client hadn’t been paid any bonus.)

More background on elitism at Societe Generale:

WSJ: Kerviel Felt Out of His League

January 31, 2008; Page C1

In 2005, Jérôme Kerviel got the biggest break of his career: a promotion out of Société Générale SA’s lowly back office — a place so uncool it was dubbed “the mine” — and into a coveted job as a trader at the powerful bank.

But if clawing your way up from the mailroom wins you a badge of honor in the U.S., not so within in the rigid class system that defines the upper ranks of French finance. Mr. Kerviel’s effort to impress his colleagues now appears to be a motivating factor behind his disastrous trading spree, which burned a €4.9 billion ($7.3 billion) hole in Société Générale’s books.

“I was held in lower regard than the others because of my educational and professional background.” Mr. Kerviel told prosecutors over the weekend. His comments were from a transcript and confirmed by prosecutors and his lawyer.

Trading might not be rocket science, but Société Générale has a tradition of drawing its star traders from France’s most elite schools. Many have doctorates in disciplines such as astrophysics or nuclear science. They are known as “quants” for the complex “quantitative” mathematical trading formulas they develop. They pull down the biggest paychecks.

The bank’s top brass, including investment-banking head Jean-Pierre Mustier, is from the engineering school Polytechnique, the M.I.T. of France. Chief Executive Daniel Bouton graduated from the prestigious Ecole Nationale d’Administration, a school known for churning out high-level government functionaries that run the country.

“If you graduated from ENA or Polytechnique, you have an absolute tenure; if not, you miss out on all the good job opportunities,” according to a former Société Générale executive. “This rift exists all over the bank.”

French authorities placed Mr. Kerviel under formal investigation Monday on charges of forgery, breach of trust and breaking into computer systems. He was released but barred from leaving the country. Société Générale has accused him of fraudulent trading that at one point left the bank exposed by €50 billion.

“His career path made him sort of an exception,” says Mr. Mustier.

It hasn’t always been this way. Société Générale’s current corporate culture is a byproduct of the bank’s transformation in the late 1980s from a conventional retail bank to a major player on the global financial stage, according to Michel Marchet, a representative of one of the bank’s labor unions and 40-year employee. When he started, Mr. Marchet recalls, even employees without college degrees could build successful careers.

Suddenly, they found themselves overshadowed by new recruits plucked from France’s top-notch schools. The rise of a new “elite” class, Mr. Marchet says, also meant “fewer working-class people were joining the bank.”

The high-pressure atmosphere has taken its share of victims. In June, a trader in his 30s who worked on the same floor as Mr. Kerviel jumped to his death from a footbridge near Société Générale’s towering headquarters in the La Défense suburb of Paris. Moments before his death, Mr. Marchet says, a supervisor had interrogated the trader for losing about €9 million in unauthorized trades. “He took his bag, left Société Générale and jumped off a bridge,” Mr. Marchet says.

A spokeswoman at Société Générale declined to comment on social tensions at the bank. She confirmed that an employee committed suicide last year.

That death came in the wake of two other suicides in recent years. In 2005, a trader jumped to his death from a ninth-floor window at the bank’s headquarters, Mr. Marchet said. A year later, a back-office employee jumped in front of a train commuting between La Défense and the center of Paris.

The trading desk where Mr. Kerviel landed, the “Delta One” unit, deals with trades aimed at making small profits with stock-market fluctuations. Mr. Kerviel, who hails from a small town in Brittany and graduated from a little-known university, suggested in his statement to prosecutors that he hoped to curry favor with people who counted.

Mr. Kerviel’s job was to invest by simultaneously taking opposite bets on the direction of the markets. The bets were supposed to mostly offset each other in what is typically a low-risk way to make a small profit. But starting in November 2005, Mr. Kerviel started placing bets only in one direction, hoping for far bigger gains.

To hide his strategy, he created a set of parallel fake bets in the other direction to give his supervisors the illusion that his books were correctly balanced.

When his supervisors asked him about unusual transactions, Mr. Kerviel would rely on simple tricks to evade their inquiries. “I fabricated a fake mail using a feature in our in-house messaging system, a function which allows you to reuse the electronic letterhead I had received and change the body of the text,” he said.

At first, Mr. Kerviel’s strategy paid off — too well, in fact. His gains snowballed so quickly that, at some point, he had locked in a gain of €1.6 billion, about a third of the bank’s overall net profit in 2006.

At that moment, “I don’t know what to do,” Mr. Kerviel told investigators. “I am happy, proud, but I don’t know how to justify my gains.”

What seemed to disappoint Mr. Kerviel was that his trading prowess wasn’t being acknowledged. He told prosecutors that he believes managers were aware of his methods but never spoke up as long as things were going well.

“I cannot believe that my superiors did not realize the amount I was risking,” he said in the interrogation. “It is impossible to generate such profit with small positions. That’s what leads me to say that while I was [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading.

Written by infoproc

January 31, 2008 at 4:53 pm

Societe Generale: a proud giant laid low

with one comment

The initial reports are confirmed; Kerviel used hacking to hide his trades: stolen passwords, fake accounts, deep knowledge of the risk management systems. The Times correctly reports (unlike, e.g., the network news this weekend) that although SocGen’s losses in closing out the positions totaled around $7 billion, the size of the actual positions was an order of magnitude larger.

Below is some background on Societe Generale, the second largest bank in France, originally established by Napoleon. Their equity derivatives business accounts for 20 percent of total profits and employs 3,500 people. (As I mentioned in a previous post, none of the U Oregon honors college students I polled knew what a derivatives trader was. France on the other hand is traditionally strong in mathematics and finance.) Legendary figure Jean-Pierre Mustier helped pioneer the derivatives business in Europe.

NYTimes: Mr. Mustier, a native of Clermont-Ferrand in the Auvergne region of France, has become the bank’s point man on the scandal, shepherding reporters through the details of Mr. Kerviel’s trades while frequently conferring with his boss, Daniel Bouton, the bank’s chief executive.

And as a former student at two of France’s most elite engineering schools — the École Polytechnique and the École des Mines — Mr. Mustier, 47, exhibits the cool, disciplined style that alumni of those institutions are known for.

When asked what his personal reaction was to the rogue trades, he said, “It was not the time for personal feelings, but for actions.”

Although the local cemetery that abuts Société Générale’s mirrored headquarters on the outskirts of Paris might give more superstitious employees pause, the bank’s traders have long been known for the cockiness that comes with high salaries and pedigrees from France’s best engineering schools. (In fact, Mr. Kerviel’s salary of roughly 100,000 euros, or $147,000, would have put him at the low end of the bank’s pay scale for traders.)

And Société Générale traditionally has shown more boldness than other, more conservative giants of French industry. When French banks were privatized in the 1980s, Société Générale was the first to emerge from government control, starting in July 1987. Mr. Mustier’s innovative derivatives trade on the Paris Bourse, in fact, took place just two months afterward, in September 1987.

Mr. Mustier was recruited to the bank by Antoine Paille, a fellow whiz kid who graduated from the École Nationale de la Statistique et de l’Administation Economique, before starting the bank’s derivatives desk in the mid-1980s.

With French banks still sleepy after decades of state control and far behind their more aggressive foreign counterparts in global capital markets, the two men set out to make Société Générale a world leader in the emerging field of derivatives.

And by hiring young mathematicians and quantitative analysts, or quants, from the Grandes Écoles, the country’s prestigious and highly elitist state schools, to help them create complex formulas that are the bedrock of the trade, they managed to do that.

From just 25 people in 1990, the equity derivatives division at the bank now employs 3,500 people. (Mr. Paille has since left the bank and is a derivatives executive at Commerzbank of Germany.)

In 2006, Société Générale earned 5.2 billion euros in net income. Its corporate and investment unit contributed 2.3 billion euros to the bank’s profit.

Profit in the field pioneered by Société Générale mounted as swiftly as one of the graphs in of their elegant mathematical models. Over all, the bank’s derivatives unit accounts for an estimated 20 percent of the bank’s total profit, according to various estimates by analysts.

And until the fraudulent trades, the company’s shares had outperformed those of its European peers, including bigger rivals like Deutsche Bank and BNP Paribas, for six of the last eight years.

According to a Merrill Lynch report from December, Société Générale expected a 10 percent growth in its equity derivatives business this year thanks to retail customers and emerging markets growth. What is more, because it relies so much on computer programs and systems, rather than on manpower, the business is highly profitable.

Mr. Mustier and Mr. Bouton will be spending the coming days answering questions about how Mr. Kerviel could possibly have wagered more than $70 billion without being detected — and whether he had indeed acted alone, as they both insist. But broader questions are likely to be asked about the safety of the derivatives business and whether French banks have placed too many of their bets on it.

“What used to be an excellent management team sitting on an enviable retail franchise and a global leadership position in derivatives is now a management under pressure suffering from a lack of confidence,” the Merrill Lynch analysts Antonio Guglielmi and Alberto Segafredo said in a recent report.

Written by infoproc

January 28, 2008 at 4:23 am

Fake alpha, tail risk and compensation in finance

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I highly recommend this essay in the Financial Times. It notes that current banking and money management compensation schemes create incentives for taking on tail risk (which is really beta) and disguising it as alpha. The proposed solution: holdbacks or clawbacks of bonus money. This would probably be a big improvement over the status quo (although how long would one have to wait to be sure that risk was properly priced on a group of thirty year loans?). When will shareholders smarten up and enforce this kind of compensation scheme on management at public firms? Clawbacks already happen in VC when early success turns into losses for a fund.

A minor quibble with what is written about VCs: in many cases “activism” is too strong a characterization — it is the inventor/entrepreneur who does all the work.

FT: Bankers’ pay is deeply flawed

By Raghuram Rajan

Published: January 8 2008 18:04 | Last updated: January 9 2008 16:21

Summary: Raghuram Rajan says bogus alpha is created by hiding long-tail risks, as with structured products linked to subprime mortgages. A solution would be to hold in escrow a big chunk of bonuses until the full risks play out, meaning only true alpha gets jumbo rewards and reducing the hidden risks in the financial system.

Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market. The chief executive, John Mack, however, assumed some responsibility and agreed to take no bonus for 2007 – although he got a $40m payout for 2006.

Even so, most readers would suspect something is not right here. Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis.

The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha. Shareholders in asset management firms, such as commercial banks, investment banks and private equity or insurance companies are unlikely to pay the manager much for returns from beta risk. For example, if the shareholder wants exposure to large traded US stocks she can get the returns associated with that risk simply by investing in the Vanguard S&P 500 index fund, for which she pays a fraction of a per cent in fees. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risks. Hence they will pay for alpha.

In reality, there are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. Warren Buffett, the US billionaire investor, certainly has it, yet this special ability is, by definition, rare.

A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage and an idea into a fully fledged, profitable and professionally managed corporation creates alpha.

A third source of alpha is financial entrepreneurship or engineering – creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.

Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities – to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.

For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compens ation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.

True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool. At the very least, shareholders deserve better explanations. More generally, unless we fix incentives in the financial system we will get more risk than we bargain for. Unless bankers offer these better explanations, their enormous pay, which has been thought of as just reward for performance, will deservedly come under scrutiny.

The writer is a professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the International Monetary Fund

Written by infoproc

January 27, 2008 at 12:13 am

L’Affaire Kerviel and a rogues’ gallery of rogue traders

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Societe Generale’s L’Affaire Kerviel is unbelievable, and I suspect we’ll be learning some interesting details in the coming days. A unique aspect of his case is that he started in the back office before making it to the trading desk, and used his knowledge of SocGen’s systems to mask his positions. But why did he do it? If his trades had been successful I don’t see how he could have profited personally. As a junior trader he couldn’t walk up to his boss and say “See, I made you 4 billion Euros, where is my bonus?” — he would have been fired right away for taking the positions in the first place. And, despite his back office acumen I don’t see how he could have gotten the profits out of the bank without anyone knowing. It almost seems as if his goal from the beginning was to bring down the bank.

NYTimes: A Spiral of Losses by a ‘Plain Vanilla’ Trader

PARIS — On the elite trading floors here, where France’s brightest minds devise some of the most complex instruments in global finance, few people noticed Jérôme Kerviel.

He was lucky to be there at all. Many of his colleagues had been plucked from the prestigious Grandes Ecoles — the Harvards and M.I.T.’s of France — and wielded advanced degrees in math or engineering. Mr. Kerviel arrived from business school and started out shuffling paper in the back office.

But on Thursday the world came to know Mr. Kerviel, 31, as the most dangerous accused rogue trader ever, a young gambler who found himself sucked into a spiral of losses that left a $7.2 billion hole in Société Générale, one of France’s largest and most respected banks.

While Société Générale executives maintained that he had acted alone, many questioned how that was possible given the scope of the losses.

“There are plenty of excellent brains at Société Générale, consequently I find it hard to believe the risk management systems and all the auditors did not indicate anything at any level,” said Hélyette Geman, a professor of mathematical finance at ESSEC, a leading French business school, as well as professor at the University of London.

It is a remarkable turn of events for Société Générale, which since the mid-1980s has built itself into a global powerhouse in trading derivatives like futures and options.

“In France we considered Société Générale a magic bank,” Ms. Geman said.

Until now Société Générale, unlike many Wall Street banks, had seemingly sailed through the turmoil in the financial markets with its reputation intact. The January issue of Risk, a monthly magazine about risk management and derivatives, named the bank its “Equity Derivatives House of the Year.”

But Mr. Kerviel, described by bank executives as a shy junior trader, did not fit the mold at Société Générale. The bank lures its top talent from the country’s premier science and engineering schools in Paris. Mr. Kerviel grew up in Brittany, in western France, and attended the University of Lyon. He joined Société Générale in 2000 as what was effectively a clerk, processing and recording the trades made on the trading floor.

By 2006, Mr. Kerviel had worked his way up to the trading floor, where he specialized in arbitrage, or making bets on small difference between various European stock market indexes such as the CAC in France and DAX in Germany.

A senior banker at Société Générale described Mr. Kerviel “as a very junior trader, not a star.” As far as his superiors knew, this banker said, “he was starting to work on a small portfolio. He’s more of a shy person than an extrovert.”

All the same, covering the billions in market positions would have taken considerable skill. “Hiding it was a full-time job because you needed to know exactly what do,” this banker said.

The chief executive of Société Générale’s corporate and investment banking unit, Jean-Pierre Mustier, insisted that the bank’s own investigation showed what they termed the rogue trader to have acted without the knowledge or cooperation of his superiors.

“We’ve been going through the positions for four days,” Mr. Mustier said. “The research we have made has not shown any link with anyone else at Société Générale.”

Mr. Kerviel’s bad bets in the markets came to light a week ago. According to bankers familiar with the situation who asked for anonymity because the investigation was continuing, risk control specialists at the bank first discovered the suspicious trades on Friday. After combing through trading records all day Saturday, the executives discovered the extent of the fraud.

Mr. Mustier returned to Paris from London to oversee the investigation at Société Générale’s headquarters over the weekend. Mr. Kerviel was summoned and was questioned there Saturday night.

Among financial veterans of other trading floors as well as financial experts across Europe on Thursday, there was widespread incredulity that a junior employee like Mr. Kerviel could have racked up such huge losses without the knowledge of his superiors.

Like Nick Leeson, the trader who brought down Barings bank by making huge secret bets on Asian markets in 1995, Mr. Kerviel was something of an anomaly on Société Générale’s trading floor.

“I had students who have a hard time getting jobs at top French banks because of this elite system we have in France,” said Ms. Geman. “In the U.K. and U.S., it’s less of a club based on where you went to school when you were 19 or 20.”

According to officials at the bank, Mr. Kerviel’s losses came from bets made on what they termed “plain vanilla products,” relatively simple futures tied to major European stock indexes.

He had made bullish bets, a senior banker said, which were gradually unwound over the first three trading days of this week. The banker insisted that the closing of those positions had not contributed to the huge losses on European bourses Monday and Tuesday.

Adding to the mystery is the conclusion by Société Générale executives that Mr. Kerviel had not profited from his trades.

“We have no explanation for why he took these positions, and we have no reason to believe he benefited from a financial point of view,” the banker said. “We don’t understand why he took such a massive position.”

The Journal has a bit more; looks like a bit of hacking + rogue trading. A new combination?

WSJ: …Société Générale’s computer systems are considered some of the most complex in banking for handling equity derivatives, that is, investment contracts whose value moves with the value of other assets. Officials of the bank believe Mr. Kerviel spent many hours of hacking to eliminate controls that would have blocked his super-sized bets. Changes he is said to have made enabled him to eliminate credit and trade-size controls, so the bank’s risk managers couldn’t see his giant trades on the direction of indexes.

Mr. Citerne said the bank didn’t notice the unauthorized trading until last week because the trader had “intimate and malicious” knowledge of its procedures and knew at what dates checks were conducted. “Each time he took a position one way, he would enter a fictitious trade in the opposite direction to mask the real one,” Mr. Citerne said. According to one person familiar with the situation, Mr. Kerviel used the computer log-in and passwords of colleagues both in the trading unit and the technology section.

According to one person familiar with events, the bank’s controls did red-flag an outside trading partner of the bank, whose account showed unusually high finance levels. The client, when asked by the bank about the account’s finances, denied knowing of it. Pursuing this matter ultimately led to Mr. Kerviel.

Executives called him in for questioning on Saturday, said Mr. Bouton. The interrogation took a good part of the day because Mr. Kerviel had convinced himself that he had mastered a new way to trade stock-index futures, according to a person familiar with the situation. For a while, he went in circles while justifying the trading strategy, this person said, but finally on Saturday night he broke down and admitted the trades.

Wikipedia has an entry on largest trading losses. I don’t really think of John Meriwether of LTCM (or even, I guess, Brian Hunter) as a rogue trader, although I suppose their investors didn’t know exactly what they were up to.

Name Amount Lost Citizenship Employer Source of Loss Year

Jérôme Kerviel[1] US$7.1 billion France Société Générale European Index futures 2008

Brian Hunter[2] US$6.5 billion Canada Amaranth Advisors Gas futures 2006

Giancarlo Paretti[3] US$5.0 billion Italy Crédit Lyonnais Loans to Hollywood Studios 1990

John Meriwether[4] US$4.6 billion United States Long Term Capital Management Interest Rate and Equity Derivatives 1998

Yasuo Hamanaka US$2.6 billion Japan Sumitomo Corporation Copper futures 1996

Wolfgang Flöttl, Helmut Elsner US$2.5 billion Austria BAWAG Currency- and interest swaps 2006

Robert Citron US$1.7 billion United States Orange County Interest Rate Derivatives 1994

Heinz Schimmelbusch US$1.6 billion Germany Metallgesellschaft Oil Futures 1993

Nick Leeson US$1.4 billion United Kingdom Barings Bank Nikkei Futures 1995

Written by infoproc

January 25, 2008 at 5:13 pm

Posted in finance, kerviel, socgen

L’Affaire Kerviel and a rogues’ gallery of rogue traders

with 3 comments

Societe Generale’s L’Affaire Kerviel is unbelievable, and I suspect we’ll be learning some interesting details in the coming days. A unique aspect of his case is that he started in the back office before making it to the trading desk, and used his knowledge of SocGen’s systems to mask his positions. But why did he do it? If his trades had been successful I don’t see how he could have profited personally. As a junior trader he couldn’t walk up to his boss and say “See, I made you 4 billion Euros, where is my bonus?” — he would have been fired right away for taking the positions in the first place. And, despite his back office acumen I don’t see how he could have gotten the profits out of the bank without anyone knowing. It almost seems as if his goal from the beginning was to bring down the bank.

NYTimes: A Spiral of Losses by a ‘Plain Vanilla’ Trader

PARIS — On the elite trading floors here, where France’s brightest minds devise some of the most complex instruments in global finance, few people noticed Jérôme Kerviel.

He was lucky to be there at all. Many of his colleagues had been plucked from the prestigious Grandes Ecoles — the Harvards and M.I.T.’s of France — and wielded advanced degrees in math or engineering. Mr. Kerviel arrived from business school and started out shuffling paper in the back office.

But on Thursday the world came to know Mr. Kerviel, 31, as the most dangerous accused rogue trader ever, a young gambler who found himself sucked into a spiral of losses that left a $7.2 billion hole in Société Générale, one of France’s largest and most respected banks.

While Société Générale executives maintained that he had acted alone, many questioned how that was possible given the scope of the losses.

“There are plenty of excellent brains at Société Générale, consequently I find it hard to believe the risk management systems and all the auditors did not indicate anything at any level,” said Hélyette Geman, a professor of mathematical finance at ESSEC, a leading French business school, as well as professor at the University of London.

It is a remarkable turn of events for Société Générale, which since the mid-1980s has built itself into a global powerhouse in trading derivatives like futures and options.

“In France we considered Société Générale a magic bank,” Ms. Geman said.

Until now Société Générale, unlike many Wall Street banks, had seemingly sailed through the turmoil in the financial markets with its reputation intact. The January issue of Risk, a monthly magazine about risk management and derivatives, named the bank its “Equity Derivatives House of the Year.”

But Mr. Kerviel, described by bank executives as a shy junior trader, did not fit the mold at Société Générale. The bank lures its top talent from the country’s premier science and engineering schools in Paris. Mr. Kerviel grew up in Brittany, in western France, and attended the University of Lyon. He joined Société Générale in 2000 as what was effectively a clerk, processing and recording the trades made on the trading floor.

By 2006, Mr. Kerviel had worked his way up to the trading floor, where he specialized in arbitrage, or making bets on small difference between various European stock market indexes such as the CAC in France and DAX in Germany.

A senior banker at Société Générale described Mr. Kerviel “as a very junior trader, not a star.” As far as his superiors knew, this banker said, “he was starting to work on a small portfolio. He’s more of a shy person than an extrovert.”

All the same, covering the billions in market positions would have taken considerable skill. “Hiding it was a full-time job because you needed to know exactly what do,” this banker said.

The chief executive of Société Générale’s corporate and investment banking unit, Jean-Pierre Mustier, insisted that the bank’s own investigation showed what they termed the rogue trader to have acted without the knowledge or cooperation of his superiors.

“We’ve been going through the positions for four days,” Mr. Mustier said. “The research we have made has not shown any link with anyone else at Société Générale.”

Mr. Kerviel’s bad bets in the markets came to light a week ago. According to bankers familiar with the situation who asked for anonymity because the investigation was continuing, risk control specialists at the bank first discovered the suspicious trades on Friday. After combing through trading records all day Saturday, the executives discovered the extent of the fraud.

Mr. Mustier returned to Paris from London to oversee the investigation at Société Générale’s headquarters over the weekend. Mr. Kerviel was summoned and was questioned there Saturday night.

Among financial veterans of other trading floors as well as financial experts across Europe on Thursday, there was widespread incredulity that a junior employee like Mr. Kerviel could have racked up such huge losses without the knowledge of his superiors.

Like Nick Leeson, the trader who brought down Barings bank by making huge secret bets on Asian markets in 1995, Mr. Kerviel was something of an anomaly on Société Générale’s trading floor.

“I had students who have a hard time getting jobs at top French banks because of this elite system we have in France,” said Ms. Geman. “In the U.K. and U.S., it’s less of a club based on where you went to school when you were 19 or 20.”

According to officials at the bank, Mr. Kerviel’s losses came from bets made on what they termed “plain vanilla products,” relatively simple futures tied to major European stock indexes.

He had made bullish bets, a senior banker said, which were gradually unwound over the first three trading days of this week. The banker insisted that the closing of those positions had not contributed to the huge losses on European bourses Monday and Tuesday.

Adding to the mystery is the conclusion by Société Générale executives that Mr. Kerviel had not profited from his trades.

“We have no explanation for why he took these positions, and we have no reason to believe he benefited from a financial point of view,” the banker said. “We don’t understand why he took such a massive position.”

The Journal has a bit more; looks like a bit of hacking + rogue trading. A new combination?

WSJ: …Société Générale’s computer systems are considered some of the most complex in banking for handling equity derivatives, that is, investment contracts whose value moves with the value of other assets. Officials of the bank believe Mr. Kerviel spent many hours of hacking to eliminate controls that would have blocked his super-sized bets. Changes he is said to have made enabled him to eliminate credit and trade-size controls, so the bank’s risk managers couldn’t see his giant trades on the direction of indexes.

Mr. Citerne said the bank didn’t notice the unauthorized trading until last week because the trader had “intimate and malicious” knowledge of its procedures and knew at what dates checks were conducted. “Each time he took a position one way, he would enter a fictitious trade in the opposite direction to mask the real one,” Mr. Citerne said. According to one person familiar with the situation, Mr. Kerviel used the computer log-in and passwords of colleagues both in the trading unit and the technology section.

According to one person familiar with events, the bank’s controls did red-flag an outside trading partner of the bank, whose account showed unusually high finance levels. The client, when asked by the bank about the account’s finances, denied knowing of it. Pursuing this matter ultimately led to Mr. Kerviel.

Executives called him in for questioning on Saturday, said Mr. Bouton. The interrogation took a good part of the day because Mr. Kerviel had convinced himself that he had mastered a new way to trade stock-index futures, according to a person familiar with the situation. For a while, he went in circles while justifying the trading strategy, this person said, but finally on Saturday night he broke down and admitted the trades.

Wikipedia has an entry on largest trading losses. I don’t really think of John Meriwether of LTCM (or even, I guess, Brian Hunter) as a rogue trader, although I suppose their investors didn’t know exactly what they were up to.

Name Amount Lost Citizenship Employer Source of Loss Year

Jérôme Kerviel[1] US$7.1 billion France Société Générale European Index futures 2008

Brian Hunter[2] US$6.5 billion Canada Amaranth Advisors Gas futures 2006

Giancarlo Paretti[3] US$5.0 billion Italy Crédit Lyonnais Loans to Hollywood Studios 1990

John Meriwether[4] US$4.6 billion United States Long Term Capital Management Interest Rate and Equity Derivatives 1998

Yasuo Hamanaka US$2.6 billion Japan Sumitomo Corporation Copper futures 1996

Wolfgang Flöttl, Helmut Elsner US$2.5 billion Austria BAWAG Currency- and interest swaps 2006

Robert Citron US$1.7 billion United States Orange County Interest Rate Derivatives 1994

Heinz Schimmelbusch US$1.6 billion Germany Metallgesellschaft Oil Futures 1993

Nick Leeson US$1.4 billion United Kingdom Barings Bank Nikkei Futures 1995

Written by infoproc

January 25, 2008 at 5:13 pm

Posted in finance, kerviel, socgen