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Rip-Offs Can Happen Here Too

By John Dietz - Email Editor

Date : 29-Jan-2008

Remember Enron? We humans have a wonderful capacity for diminishing memories. Last week the largest white-collar fraud in history of $7.16 billion was announced as a “rip-off” from the French bank Société Générale.

France’s #2 bank uncovered the scheme at about a $1.4 billion loss before last weekend (mid January), but with the market downturn, the loss snowballed to over $7 billion within the week. Once found, the bank tried to initiate steps to recover before announcing the dilemma to the market.

The alleged fraud is one of the largest in history, and the largest ever by a single trader, Jerome Kerviel, a junior level trader, dwarfing the $1.38 billion loss by futures trader Nick Leeson that bankrupted Britain's Barings Bank in 1995.

It is eerie to think that one “rogue” trader, as he is now being referred to, could cause such a global shake up. Kerviel had been a bank employee for eight years and in the black until a bizarre set of details occurred that are still unfolding. He had been noted to be an introverted employee who had recently been depressed over his father’s death and a divorce after a two-year marriage. His family cites him as anything but a criminal, and it appears that he gained nothing and lost nothing personally from the debacle.

Officials worked quickly to cover Kerviel’s trading positions, which were discovered at a loss around January 13th, but by Monday, January 21st, because of the volatility of the market and the size of the loss, on this single-day, SocGen lost an amount equivalent to their 2006 total profit. Many investors believe that the massive sell-offs by SocGen on this single day caused the market further trouble last week.

Kerviel traded "plain vanilla" equity futures on various Europen markets. He had been ahead of the game for most of 2007, correctly betting the markets would decline. In 2008, the rogue, workaholic trader switched his bet to a decision that the market would recover.

Without getting too specific, futures contracts that investors buy represent just a fraction of the value of their position due to leveraging. For example, for $5,000 an investor can purchase a position that, after leveraging, represents $50,000 worth of equity. If the bet loses, the value of the loss could rise to $50,000.

Kerviel covered up the huge bullish position of these grossly overleveraged fake purchases with bearish hedges. SocGen has said that Kerviel has admitted to a “scheme of elaborate fictitious transactions” but the details have yet to be proven in a court of law.

Though we know this haunts Wall Street, it is unusually quiet in the media for a disaster of this magnitude. If you type in French trader and $7 billion loss, it comes up on Google 738,000 times. If you type in Mary Kate Olsen and Health Ledger, it comes up 2,540,000 times. Type in Jerome Kerviel alone and it comes up 2,258 times. It appears that losing money is no match for Hollywood.

Jerome Kerviel’s final bet was a leveraged $73.3 billion, which equates to a cash loss of approximately $7.16 billion.

"It was an extremely sophisticated fraud in the way it was concealed," said Société Générale Chairman, Daniel Bouton, whose offer to resign in the wake of the scandal was rejected by the company's board.

It is alleged that the junior trader was able to use an intricate layer of bank safety nets to cover the losses he was incurring on a daily basis.

Responsibility

This scenario is the poster child for self-responsibility (an obvious oxymoron), but impossible to overstate in today’s world.

SocGen was able to quietly recover to keep from going bankrupt without any announcements. The loss on Friday was $7.16 billion, which is larger than their capitalization, yet it appears they will recover only because they were able to keep it a secret and “sell-off” before larger competitors found out.

By comparison, if Citigroup, with a market cap of $133 billion, was the victim of a similar fraud, estimating the loss at $170 billion, it would have to sell off over $20 billion of subprime mortgage investments and take a 50 percent hit to its stock.

How is it that any trader or fiduciary can take a position of such leveraging without being spotted or audited? In the day of sophisticated computers, I think everyone on Wall Street is scratching their head over this, yet the lunchtime murmur is “it happens”. A dysfunction of this level, though not the first time in our history, drives deep concern into most investors.

As I have been saying, the global economy affects us all, and last week we saw it and felt it. What happened last week at Societe’ Generale’ could happen here at any time even under better laws and supervision. This is a sound reason to protect your portfolios and assets in every way available.

We live under an extensive compliance system that does not always secure us as individuals and sometimes protects public interest to a greater extent than it does our family wealth. It is better to protect your assets now then to try and save them in the future.

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