Vanilla to blame for global crisis in stock markets?

moneymajix said:

http://business.timesonline.co.uk/t...ectors/banking_and_finance/article3248746.ece

From The Times

January 25, 2008

Did rogue trader set off world market panic?

Jérôme Kerviel believed that he was executing a brilliant trading strategy. Instead, the trader’s activities over the past year appeared yesterday to have cost his employer, Société Générale, €4.9 billion (£3.7 billion), and fuelled a global crisis in stock markets.

The 31-year-old’s web of lies and trades began to unravel late on Friday, as his supervisors spotted an anomaly in his handling of futures contracts on European stock market indices. On Saturday Mr Kerviel was hauled into the bank’s Paris offices where he was questioned by Jean-Pierre Mustier, SocGen’s head of investment banking, and confessed to making a series of unauthorised bets on CAC, DAX and the EuroStoxx 50.

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Dear XXXXXXXXXX,
John Stepek

Panic’s over!

It’s OK, we can all stop worrying about the state of the financial markets and the global economy now. We’ve found the culprit.

The recent carnage in the markets was all down to one man. No, not Alan Greenspan, but Jerome Kerviel, a trader at French bank Societe Generale. The short version is that Mr Kerviel managed to circumvent the bank’s risk management systems, placing huge unauthorised bets on which direction markets would move in. He was discovered at the weekend, and the bank had to unwind the bets.

Of course, when SocGen started to unwind these bets on Monday, all that activity panicked the markets, sending them to the depths we saw in the last few days. In the process, SocGen lost £3.7bn – the biggest “rogue trader” loss ever seen.

It’s an appealing idea. Now the markets have caught the wrong-doer, we can get back to business as usual.

But it’s also a complete fiction…

More than a few commentators are trying to push the idea that the recent market chaos was all down to bets made by the ‘rogue trader’ at Societe Generale being unwound.

Where will the next rogue trader be found?

Now I’m not saying it didn’t have an impact. After all, as Edward Hadas points out on Breakingviews, “the bank must have sold something like 50bn euros worth of shares, the value of long positions required to lose [£3.7bn] in the first few weeks of 2008”.

But sadly, the theory that he was the sole cause of the market collapse doesn’t stand up to scrutiny. Monday’s market collapse began in Asia, where stocks sold off drastically overnight, before SocGen began its great sell-off. So while the idea that the Fed panicked and slashed interest rates solely because of the actions of a French Nick Leeson is quite amusing, it’s also somewhat exaggerated.

However, the story does flag up yet another reason for investors to be worried about what’s lurking behind the façade of the recent boom times. Many wise investors have pointed out in the past, that fraud which goes unnoticed during the good times, rapidly becomes obvious when things start to turn bad.

As Warren Buffett puts it, it’s not until the tide goes out that you see who’s been swimming without any trunks on.

So one obvious concern is that – if this chap could get away with it, who else is getting away with similar scams? It also shows just how much damage derivatives can do. Mr Buffett once called them “weapons of mass financial destruction” and SocGen, having been pushed into a multi-billion euro emergency rights issue, would have to agree with him.

These bets weren’t even terribly complicated. They were straightforward bets on the market rising or falling. Nothing to do with sub-prime or mortgage-backed securities or any of the other buzzwords of 2007. In other words, not where we’d have been expecting the occasions of mass fraud to crop up.

How you and I end up paying for banks’ mistakes

In many ways, SocGen – and by extension, the financial system – was lucky that Mr Kerviel slipped up when he did, or things could have become far worse. As Patrick Hoskings points out in The Times, having racked up billions in losses already, there’s no reason he couldn’t have racked up billions more. Instead of an emergency rights issue, SocGen could have been looking at outright bankruptcy.

And if that had happened, we’d all have had to pay for it. As Hoskings says, some banks are deemed “too big to be allowed to fail… Governments would undoubtedly be obliged to bail out any major bank in trouble. The squillions of dollars of bets placed every day in the wholesale money markets by such banks are underwritten by taxpayers.”

If you’re in any doubt about that, just look at the panic our own government got into over Northern Rock. The Rock is a pretty unimportant bank even within Britain, let alone on a global scale. Yet it was deemed too big to fail and has now caused untold damage to an already ugly-looking public sector balance sheet.

If nothing else, the first few weeks of 2008 have proved that we are in for a rough ride. In this week’s MoneyWeek magazine (out today), our editor Merryn Somerset Webb picks out the best places to put your money now. If you’re not already a subscriber, you can get your first three issues free by clicking here: 3-issues free trial (http://www.moneyweek.com/file/194/subscribe-from-not-logged-in.html).

Turning to the wider markets…

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But sadly, the theory that he was the sole cause of the market collapse doesn’t stand up to scrutiny. Monday’s market collapse began in Asia, where stocks sold off drastically overnight, before SocGen began its great sell-off. So while the idea that the Fed panicked and slashed interest rates solely because of the actions of a French Nick Leeson is quite amusing, it’s also somewhat exaggerated.

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Kauri said:

But sadly that theory doesn’t stand up to scrutiny either. Even isolated little me had caught a whiff of it on tother side of the world.. on Sat night.. in fact it smelt like a blowie left on the rocks of the Dawseville channell for a couple of days.. Alot of the Asianselling was down to peoples knowing what was coming.. I thunk..

Cheers
..........Kauri

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wayneL said:

So "they" knew all along.

Bastids!

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Dear CIGAs,

The theme concerning the recent market drop and involving Monday morning’s Fed action is that the Federal Reserve cut rates significantly assuming a freefalling equity market to be a product of panic. This theme suggests panic is capable of producing more panic and therefore furthering the potential of the fall.

In the timeframe leading up to and during the freefall of equity values, a major French bank was having a just recently discovered significant problem liquidating a hidden position of equities in some form or another. This liquidation by the major French Bank, although unsaid, implied that action has taken the market down significantly in the week preceding the Fed action.

Consequently, there really is no economic or derivative problem that was at the heat of the extreme drop of equity values, nor does it mean anything that the major drop took place on the news of AMBAC bond downgrading, a major player in default derivatives.

As such, the Fed acted somewhat in error as a result of not knowing the French bank’s activity as the root of the plunging equity values. The assumption since the bank reported a complete loss is that the French bank has completed its liquidation, all is well and the future is rosy.

This really quite beautiful effort of plausible denial requires some critical examination:



Question: Could a junior trader have entered into a position of such magnitude that it could make or lose $7,000 million?

Answer: It is most unlikely as personalities making transactions of this proportion are few and far between. They know each other. At minimum, the other side or sides would have inquired with the Senior Trader if the Junior Traders knew what he was doing.



Question: Could a transaction of this magnitude be successfully hidden for months?

Answer: After the Warburg/Rogue trader experience, major trading entities have tightened up their accounting and audit processes to prevent just this type of act.



It is a strain on the imagination to think that this could have been accomplished as transactions are confirmed between trading houses electronically. That confirmation process then goes to the trading entity to again confirm. Risk control in major houses then factor that into overall positions.

How a junior trader could have short cut that procedure is hard to imagine.

The thesis that a junior trader hid a gargantuan trade confirmation under his desk or that a procedure missed it is extremely unlikely to be factual.



Question: What was the form of the transaction?

Answer: By not specifically stating the media and the public would assume the trader somehow held a long position of shares that were being liquidated into the market.



That strains one’s imagination as well because such a position would be so visible that it would glow in the dark.

This leads one to assume the position was either a derivative on equity indices or mathematical equivalents derived by algorithms, not the world’s largest long position in US equities.

This leads one to assume that one side of the trade, the side which was called on to perform, could not or in the case of the bank in question selected not to perform.

As such, the loss was on a structured investment vehicle either structured by the bank in question or another.

Rarely do these special performance contracts called OVER THE COUNTER DERIVATIVES actually perform, but rather are bought out by the losing side when called to perform on.



Conclusion:

The USD $7,000 million loss reported as an action of a junior trader hiding a losing position for a considerable amount of time as stated is total bull.

You would have to be totally IGNORANT of market mechanics to buy that plausible denial.

The public and much of the media are.

The reported loss was a buyout of a failed to or chosen not to perform derivative.

The world’s equity markets broke for their own reasons and not because a large French bank was selling common shares into the marketplace as the newest and rather well done SPIN would have you think.

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By Friday, January 18, Jérôme Kerviel, a junior suit in the banking world, was on the hook for €50 billion - the equivalent of about half of all the gold and currency reserves held by France. The sum also exceeded the entire value of the bank at which he worked.

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Fed's Folly: Fooled by Flawed Futures?

In The Financial Times today the inside headline is "Markets ask if the Fed was duped?" It seems that a rogue trader (interesting how a lone trader who loses a lot of bank money is always a rogue) lost Societe Generale $7.1 million (4.9 million euros). Seems he knew how to override the risk control systems, had other employees' passwords, and built up a massive long position which was down about $2.2 billion by the time SocGen management found out. He produced the losses in just a few weeks. SocGen started selling everything to cover the loss on Monday morning, and the markets moved away from them, growing the loss to the $7.1. That constitutes a bad day at the trading desk. (As an aside, I have worked with SocGen from time to time over the years, and have always been impressed.)

Some suggest that it was the very selling by SocGen, which was 10% of the market trades, which caused the downside volatility. It seems the European Central Bank knew early on about the problems at SocGen, but the Fed got caught by surprise. The Fed holds an emergency FOMC meeting ahead of the scheduled meeting this week, and makes a shock and awe 75-basis-point cut. I can tell you that shocked a lot of very sophisticated traders and managers that I talked with here in Europe.

Everywhere I went I was asked, "Why an inter-meeting cut?" The Financial Times wrote, "The question being asked now by some in the markets is: was the Fed duped into a clumsy and panicked move by the clean-up operation for Jerome Kerviel's [AKA rogue trader at SocGen] mammoth losses for the French bank?"

My very good friend Barry Ritholtz seems to agree with that position. He was on CNBC with Steve Lissman and Rick Santoli and they suggested that the Fed responded to the volatility in the stock markets with the rate cut and that the Fed is now responding to the traders in the S&P futures pit.

Let's read Barry's take when he finds out that the volatility may have been the result of our rogue trader, in a blog entitled "Fed's Folly: Fooled by Flawed Futures?":

"Was it a misunderstanding of their mandate, inexperience, or just plain hubris?

Regardless, it took only 2 days to learn just how ill-considered the Fed's emergency market rescue plan was: To wit, a fraudulent series of losses led to a major European bank unwinding a huge trade: Societe Generale Reports EU4.9 Billion Trading Loss.

SG's $7.1Billion dollar unwinding led to panicked futures selling on Monday and Tuesday.

"Hence, we quickly learn what sheer folly and utter irresponsibility it is for the Fed to use its limited ammunition to intervene in equity prices. Their panicky rate cut was not to insure the smooth functioning of the markets, but rather, to guarantee prices.

As we have been saying for the past two days, this is not the Fed's charge. They are supposed to be maintaining price stability (fighting inflation) and maximizing employment (supporting growth) -- NOT guaranteeing stock prices.

"I guess the European Central Bank has it easier: Their only charge is to fight inflation: 'maintain price stability, safeguarding the value of the euro.' Tuesday's panicked 75 basis cut will prove to be an historical embarrassment, a blot on the Fed for all its days. Failing to understand what their responsibilities are is bad enough; allowing themselves to be bossed around by futures traders is inexcusable.

And, having been rewarded for their past tantrums, the market will now be screaming for another 75 bps next week. As Rick Santelli appropriately observed, the Pavlonian training is now complete."

I don't agree with that assessment, and Barry is not so thin-skinned that he will worry about my having a different view. So, let me throw out another scenario.

First, for years one of my central premises has been that we have to remember that when a normal human being is elected to the board of the Fed, he is taken into a secret room where his DNA is altered. Certain characteristics are imprinted. Now, he does not like inflation and hates deflation even more. He sees his role as making sure the financial market functions smoothly. He does not care about stock prices when thinking about rate cuts.

Then what was the reason for the cut if not stock prices? Why an inter-meeting cut much larger than the market was expecting next week, just seven days later? What was so urgent that we needed a shock and awe rate cut a week early?

I am not sure if panic is the right word, but I think very deep concern is also a little understated. It has to be something serious for an inter-meeting cut. Looking around for problems I came up with the following thoughts that I shared with investors and managers while here in Europe.

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numbercruncher said:

Just read an Interesting article about this incident, its just phenomenal when you think about it!




http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3257468.ece

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On Facebook, the social networking site, his home page had accumulated only 11 friends before the scandal was uncovered. Those who were there trickled away as the news of his problems broke. By Thursday night he had just four. The next morning there were none.

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numbercruncher said:

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3257468.ece

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Kauri said:

All the pressI have read over the weekend assumes that the problems in SG were kept in-house and that they had to sell into an already falling market.. compounding thier losses. Personally I find that assumption, along with a few others incidentally, rather hard to swallow.. the markets falling, starting in Asian zone and spreading to the Euro zone, was down to the SG problems being in the market already.. unequivecally.. as I have stated earlier even humble I heard on Sat. that there were problems at SG.. and in a PM to another member here was even able to quote a probable loss of 4-5Bln and mention of 45-50Bln involved.. now if I had heard why wouldn't the Fed have heard??? before thier 0.75% panic??
All the talking heads on those venerated cable channells and thier self-agrandiosing statements/rants are either self-serving twaddle... or else they are toeing someone elses line?? Which is probably giving more credence to them than they deserve. The news was filtering into the market over the weekend, enabling those that had heard it to position themselves for some impressive gains by being pro-active rather than reactive... and that obviously was more important to the "media experts come fund managers" than anything else.. as such, anything they spruik should be looked at closely.. very very closely... and no, I don't have or want cable....
I thunk...
Cheers
.........Kauri

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wayneL said:

Causative, catalytic, or symptomatic?

It's rather a big position size to be merely symptomatic. On the the other hand, if the SocGen unwind was causative, that whole down-leg would appear to be totally unwarranted and we inhabit an undervalued market.

Personally, don't buy that; not even for a microsecond. No doubt SogGen precipitated the severity of the sell-off... Buu-uut... there is no way while our @rses point to the ground that the market is undervalued, in fact, it remains substantially and chronically overvalued as we go forward into a recessionary/low growth environment.

So my conclusion is that it was simply the catalyst to bust Goldilocks' grip on the market. Of course the spin will be that Pierre Froglegs caused the crash of 2008, but the reality of course will be somewhat different.

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Reuters report.. Bert Heemskerk, chief executive of Dutch bank Rabobank said in Davos that European banks faced yet worse losses from the credit crisis saying: "Quite a few banks are heavily involved, and in particularly if you look at European banks, we have not seen the worst. The news has not been spreading out about the losses that the European banking system has to take."
Rumours were swirling in the markets on Friday that ING and Fortis (read/heard about this anywhere lately in the press/expert Jims??) might be forced to issue profit warnings at some stage and this was one of the reasons for the EUR weakening and equity markets closing the week on a sour note.

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CNN report... global finance chiefs drove home warnings over the market crisis on Saturday, as concerns of a possible recession continued to trouble the World Economic Forum meeting in Davos. IMF Director- General Dominique Strauss-Kahn said the current turmoil had reached levels never seen before. Strauss-Kahn said not even emerging economies touted as safe bets for short-term growth would escape the impact of problems that drove the Federal Reserve to deliver an emergency rate cut.
AFP reported that Strauss-Kahn said a "serious" response was required to counter the risk of a US recession and slowing global growth, including both monetary and fiscal measures. Former US treasury secretary Larry Summers said that the suggestion from the IMF that countries should increase their public spending, even countries with deficits, was seen as "an indication of the gravity of the situation we face". Summers added: "In the first time in a quarter century, the managing director of the IMF has called for an increase in budget deficits ... traditionally it's all been fiscal consolidation."

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Kauri said:

I wonder if Soc Gen, reputed to be the largest stock derivatives trading bank globally, didn't take the opportunity to position/unposition itself in other lines to possibly mitigate some of the losses they were getting set to take???

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