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By Laton McCartney
Today, the CIOZone continues its five-part investigation into the subprime credit crisis and the Societe Generale trading scandal. The fall-out of these incidents has laid bare glaring failures in risk management technology, controls, procedures and processes. But the question for CIOs: If the technology had been better, or better managed, could the mess have been avoided? Yesterday, in our attempt to answer that question, we published Part 1: Behind the Subprime Collapse. Here, we present the inside story of the Societe Generale trading scandal.
Part 2: The French Connection
Accounts of the last days of rogue trader Jerome Kerviel's career at Societe Generale, France's second largest bank, read like an excerpt from a John Grisham thriller. And as in any good thriller, there's an overriding mystery: Is the young man who single-handedly almost brought down one of France's largest and most venerable banks a criminal mastermind or a scapegoat?
From a family in Brittany of modest means—his mother was a retired hair dresser, his late father taught metal working—Kerviel was hired in 2000 by SocGen, after earning a Master's in Finance from a second tier school, University Lumière Lyon 2, specializing in organization and control of financial markets. During his first two years with SocGen, Kerviel worked in the middle office, which monitors and manages the bank's risk exposures. In 2002 he was promoted to Trader Assistant, working on risk analysis and hedging, and in March 2004, the 31-year-old was promoted to Trader and Market Maker at the bank's elite Delta One trading desk. The Delta One trading desk deals in program trading (trading a portfolio of stocks), index (the performance of an entire stock market or a sector of the market) and quantitative trading (using mathematical or statistical models).
The position at Delta One had been his goal since joining the bank, according to his curriculum vitae, which stated his objective as: "Reach a position as a retail listed derivative products trader, managing a volatility and Delta One book."
As a junior trader, Kerviel earned a salary and bonus combined of less than 100,000 euros a year (about $145,000), a relatively modest amount for his position. With bonuses, top traders at the bank can make up to 4 million euros.
At the Delta One unit, he was a distinct outsider. His new colleagues had matriculated at France's few grandes ecoles, the French equivalents of Harvard or Oxford, and were well situated in French society. "I was aware starting from my first meeting in 2005 that I was less well considered than the others as regarded to my university degree and my professional and personal background," Kerviel later said in his interrogation by investigators that appeared on the newspaper Le Monde's Website. "I...had passed through the middle office to the front office, and I was the only [trader] to have done that."
His new post, as defined by the bank, was relatively menial and low impact. He wasn't brought in to be a high roller. Anything but. "His job was to make bets on small price differences between contracts [these are equity derivatives, a class of financial instruments whose value is at least partly derived from one or more underlying equity securities], not to trade on the markets' direction," Jean-Pierre Mustier, SocGen's CEO, said in a January 27, 2008, press conference.
SocGen declined to respond to questions about the Kerviel matter despite numerous calls and emails.
Kerviel was an arbitrage trader specializing in European stock market index futures. Simply put, this meant he acquired two similar portfolios, or baskets, of stocks or other instruments with more or less comparable value. In basket A, he was "going long," betting that the portfolio's value would go up within a defined period, usually 30 days. In basket B, Kerviel was "going short," wagering that these investments would head south. The arbitrageur earns his or her keep taking advantage of any split-second price differential between these portfolios for the duration of the futures contract.
"It's low risk kind of investing, unless you get it wrong," notes Robert Youngman, a portfolio manager with Griffin Asset Management, Inc., a New York investment management firm. "You see a minor spread between the portfolios show up every once and a while and capitalize on it."
Apparently tiring of small bets, Kerviel in late 2005 made his first major score, an unauthorized transaction shorting Allianz (a German insurance company) stock, meaning he was betting on a downturn in the market. "Soon after this, the market fell, following the [terrorist] attacks in London and we had a jackpot of 500,000 euro ($750,000 today)," Kerviel told the Paris prosecutor's office.
Even though the trade went well beyond Kerviel's predetermined limits and hadn't been hedged (meaning he didn't concurrently go long on Allianz), the trader entered the transaction in the bank's proprietary computer system known internally as "Eliot," according to a preliminary report later issued by the Special Committee of the Board of Directors of Societe Generale, which was formed January 30 to investigate Kerviel's activities.
At this juncture, he also came up with a scheme to make it seem as if he actually hedged his Allianz bet through a bogus short transaction in portfolio B, where he'd henceforth carry out fictional deals—hedges to counter his real trading activities. "I already had the idea of a 'deal' to cover my (Allianz) position," he said in his interrogation. "I had mixed feelings because I was proud of the result, but surprised at the same time. That produced a desire to continue; there was a snowball effect."