The financial press here has been calling Jérôme Kerviel’s caper at Société Général “the greatest individual fraud in history” (The Guardian) with little apparent irony, at which the British normally excel. Kerviel, a junior trader, secretly entered into a series of derivatives contracts which ended up costing France’s second largest bank €4.9 billion.The Financial Times even speculated that Kerviel’s actions played a role in the declines of stock prices on Monday in the UK and Europe, which led the US Federal Reserve to cut its interbank rate to ¾ %. On Wednesday, when Société Général finally announced what happened, reporters started looking up his FaceBook page (quickly vacated by his 11 digital “friends,” so much for social networking) and interviewing neighbors and former schoolmates, quoted as saying that Jérôme had been “a serious, helpful teenager,” and a nice neighbor who was kind to their pets, comments which would lead most American readers to suggest digging up his backyard.
All of this took place, of course, in the context of the collapse of investments connected to the sub-prime mortgage industry, in which the world’s biggest banks have already lost $70 billion, and counting. The sub-prime losses are described as a natural disaster—the chief investment strategist for Merrill Lynch (loser of $23 billion) said on January 24, “There appears to be a growing global credit pandemic.” In contrast, Kerviel was a devious mastermind, who France’s top financial regulator called “a genius of fraud”; by Saturday he was in police custody. It’s reminiscent of the scene in Casablanca when Captain Renault exclaims, as he pockets his winnings, “I’m shocked, shocked to find that gambling is going on in here!”
What Kerviel did was enter into massive futures derivatives contracts, based on three European stock markets, using his knowledge of the bank’s computer systems to create numerous accounts and raise his trading limit. He then created dummy hedging positions—which the bank uses to protect itself against downside risks of the contracts—so the contracts would appear to be covered, and constantly cancelled and re-opened contracts so his supervisors wouldn’t catch on. By the end of 2007, the bank says he was around €1 billion ahead.
But when the market ran into the sub-prime mess this January, Kerviel had somehow built up positions worth €50 billion, more than SocGen is worth, and was already €1.5 billion in the red by January 19. The bank lost €3.5 billion more on Monday and Tuesday, quickly unwinding the contracts in a falling market. SocGen was not helped by the fact that it, too, has lost another €2 billion betting on sub-prime loans, which they announced on Wednesday. SocGen Chairman Daniel Bouton defended the five days of secrecy about the scandal by saying he needed to protect the bank’s shareholders. Some of those shareholders are now unhappy about being left out of the loop, especially those who bought shares on Monday and Tuesday.
It’s odd, then, that no one seems to connect the larger scandal to the smaller one. The giant bets that SocGen and other banks placed on sub-prime mortgages were not hedged, either. Whether the sub-prime crash contributed to the market losses is not under speculation—the crash caused the losses. UK pension funds are now 10% underfunded. US President Bush is pushing a $150 billion, taxpayer-funded stimulus plan including $50 in business tax breaks, to try and keep the country out of recession.
The usual explanation is that mortgages are safe investments, but it would not have been difficult to find problems with many of the loans packaging by lenders like Countrywide Financial, Armeriquest, and others who caused the crisis by making unwise loans. Community organizations in every U.S. city have been fighting their activities for years; 35 U.S. states have passed legislation, in the absence of federal actions, to regulate companies whose business is little different from loan sharking. Foreclosure rates have been rising since 2004. These were not good investments. How are Merrill Lynch, Bear Stearns, Citigroup, and SocGen itself not “rogue traders?”
To be fair, there are some major differences between Jérôme Kerviel’s derivatives trading and the investment banks’ gambles on sub-prime loans. First of all, Kerviel was not authorized to make the investments he made. As a junior trader, he made about €100,000 a year and had a trading limit. In contrast, the leaders of the big investment banks are supposed to be experts. Chuck Prince, who led Citigroup to $11 billion losses on sub-prime loans and counting, made $27 million last year.
Second, Kerviel is going to jail. Nobody, as far as I know, is going away for losing billions of pension funds’ money while ratcheting up their salaries. Some CEOs lost their jobs, including Prince, Bear Stearns’ James Cayne, and Merrill’s Stanley O’Neal.
Finally, Kerviel apparently didn’t make any money off his trades, according to SocGen. Even though his crazy scheme was €1 billion ahead in 2007, he didn’t try and cash out. Evidently he did the whole thing for fun. The Wall Street geniuses were more practical. Although the U.S. markets dropped 15% since October, the average trader got a $180,000 bonus this year. Prince, O’Neal, and Cayne walked away with massive severance packages: O’Neal, for example, will pocket another $160 million or so.
Even the sub-prime lenders did OK. Bank of America bought Countrywide Financial, the biggest subprime lender. Former Countrywide CEO Angelo Mozilo lined up a $115 million severance package, including free rides on the company jet and country club fees through 2011. Citigroup was rescued by Kuwait and Saudi Arabia, China’s sovereign fund bought a piece of Morgan Stanley, which then helped underwrite a recapitalization for SocGen.
SocGen tracked down Kerviel who had not, as early press reports speculated, fled the country, but was at his brother’s house. The only losers here are the suckers who have their money in a pension fund, or bought a house in the past five years, or actually pay their taxes.
