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Generational Dynamics Web Log for 28-Jan-08
Historic Société Générale fraud shocks world financial system

Web Log - January, 2008

Historic Société Générale fraud shocks world financial system

Did a "rogue trader" snooker Ben Bernanke and the Fed?

The details are still coming out, but the bare facts are these:

France's second-largest bank, Société Générale (SocGen), has lost $7.2 billion through fraudulent falsification of bank records and computer fraud. These are the biggest losses in banking history.

Jérôme Kerviel, a 31 year old Gen-Xer with an "enthusiasm for finance," joined SocGen in 2000, where he was able to learn how all the bank's computer systems worked, including the programs that detected possibly fraudulent actions.

In 2004, Kerviel became a full-fledged trader and market maker, earning a salary of about $130,000 per year.

"The bank alleges that he hacked into other traders’ systems and set up deals using their accounts; that he created a fictitious client so that he could trade as if setting up deals on its behalf; that he circumvented limits to the size of trades; and that he defeated credit control checks that should have picked up rogue trades, especially those that put the bank’s own money at risk.
Kerviel was apparently able to unpick or switch off all these checks. In addition, he master-minded a way of covering his trading. He apparently created fictitious trades designed to neutralise the big bets he was making so that the bank’s systems appeared to show that everything was in balance. In banking-speak, his positions were outwardly 'hedged'."

Kerviel began these activities last year. As far as is known, he didn't attempt to make any money from these transactions; perhaps he was treating the SocGen trading system as a giant video game. His trades made money in the up market that ran through December.

When the market started falling in December, he made larger and larger trades to cover his losses.

By Friday, January 18, when the fraud began unraveling, SocGen's open trades totalled €50 billion ($73 billion), which exceeded the market capitalization of the entire bank.

On Monday, January 21, after a weekend of panicky meetings by SocGen's senior management, the bank started liquidating all of Kerviel's trades. Wall Street was closed was closed on Monday, but the Asian markets and then the European markets fell sharply on Monday. As SocGen unraveled its positions, it was forced to sell its $73 billion in holdings into that market, and ended up losing $7.4 billion.

By coincidence, SocGen had planned, at the same time, to announce some $3.5 billion in writedowns of faulty mortgage-based assets, hoping to start 2008 with a clean slate. That's not going to happen now. Instead, SocGen is being forced to seek investors to bail them out.

Fearing a market rout, on Tuesday the Fed announced a ¾% emergency interest rate cut at 8:20 am. The Fed later reveals that it knew nothing about the SocGen fraud prior to interest rate cut.

On Thursday, January 24, at 0700 GMT (2 am ET), finally makes a statement about the $7.2 billion fraud.

Was the Fed snookered?

The reasoning behind the claim that SocGen snookered the Fed is as follows:

The European market rout on Monday was at least partially caused by the massive SocGen selloffs of the Kerviel's positions.

If the Fed had known what SocGen was doing on Monday, then it would have taken that into account and not announced the emergency rate cut on Tuesday.

However, SocGen did not announce the fraud until Thursday.

Frankly, I believe that this reasoning is completely backwards. If SocGen had revealed the $7.2 billion fraud on Monday, it might well have triggered an even larger selloff on Tuesday by panicky investors. At any rate, Chaos Theory tells us that it's impossible to predict the effects of one particular financial event on another particular financial event.

However, there are broader questions being asked about the SocGen fraud, and whether SocGen is covering something up.

The hard-core conspiracy theorists are suggesting that SocGen's senior management knew what Kerviel was doing all the time, and that they wanted him to do it to cover up the $3.5 billion writedown of mortgage-based securities. Before Kerviel was taken into police custody on Saturday, there were some pundits suggesting that Kerviel would never be found because he didn't exist, and was just a made-up name proffered by SocGen execs.

If we go beyond the tinfoil hat conspiracy theories, there is the following real question: How is it possible that Kerviel was acting alone, as SocGen claims, and yet was able to place fraudulent trades for many months, without being caught either by SocGen's computer systems or by its human auditors?

Even if Kerviel spent four years working in the back office, the reasoning goes, SocGen's auditing systems are far too robust and complex for one person to fool for very long.

Once again, I find this reasoning to be backwards.

In fact, it's quite possible that a single person, like Kerviel, might have understood the "soul" of SocGen's systems, but extremely unlikely that two people could have, and then agree to cooperate on this major fraud. I don't see how it's likely that more than one person, acting alone, could have pulled this off.

When I refer to the "soul" of computer systems, I'm not getting mystical. Over the years, I've reviewed hundreds of software programs, and as a consultant worked on dozens of large computer systems, and unless a computer system is dysfunctional, then it has a "soul," an internal flow, an internal consistency, an internal philosophy that ties it all together.

(This concept of a "soul" in computer systems is not unique with me. A web site reader recently reminded me of Tracy Kidder's 1981 Pulitzer prize winning book, The Soul of a New Machine, on the development of a new computer at Data General.)

It's unusual for even the programmers working on the system to understand its "soul." When I've worked on these large systems as a consultant for a few months, I've found that it's not unusual to have to explain to them how their own software works. Typically, what happens is that the original system architects, designers and programmers understand its "soul," but when they leave and are replaced by new programmers, the new ones may understand how the components work individually, but they generally never grasp the "soul" of the system as a whole. And as for management -- they really never understand a software system, except in gross functional terms.

Now, I'm sorry if the last couple of paragraphs seemed a little too mystical, since there's nothing mystical about it. It's simply that computer systems become so large and so complex, that they're too large to be fully grasped. It's like a person living in a beautiful mansion who understands what each room is for, but only the architect understands entire home as an entire system or unit.

So the point is that, based on the facts that have been released so far, here's what I consider to be the most likely scenario: Jérôme Kerviel joined the SocGen's back office in 2000, and spent four years learning SocGen's computer systems and procedures -- and he had the skill to understand the "soul" of these systems better than anyone else there. He understood the systems so well, that he understood its rhythms, its strengths and its weaknesses. When the time came, he was able to exploit his knowledge.

That's why I say that I would be surprised if it turns out that he had an accomplice. There really couldn't have been someone else as knowledgeable as Kerviel working with Kerviel, or the accomplice would already be known to the authorities.

So, in my opinion, the critics of SocGen who suspect an accomplice are likely to be wrong.

But the critics who suspect that other banks may be susceptible to the same problems. There are other programmers in other banks who understand the "soul" of those computer systems too. And if they decide to become "rogue traders" also, then we may hear a lot more about these kinds of fraud.

From the point of view of Generational Dynamics, none of this is surprising. In my recent article, "The nihilism and self-destructiveness of Generation X," I showed how the destructiveness of today's Generation-X, combined with the "Lenscap Stupidity" of the Boomer generation, makes this kind of fraud almost the norm, more than at any time since the 1920s.

In fact, in August there was a similar incident at Crédit Agricole, one of Société Générale's competitors, but costing a mere €230 million. So we haven't heard the last of this. (28-Jan-08) Permanent Link
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Generational Dynamics Web Log for 28-Jan-08 Historic Société Générale fraud shocks world financial system

Was the Fed snookered?

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Generational Dynamics Web Log for 28-Jan-08
Historic Société Générale fraud shocks world financial system