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Cyreenik Says

Thoughts on the SocGen Crisis

1 Feb 08

I've been following the SocGen Crisis that blew up a couple weeks ago. This has the potential to become another Big Panic and Blunder situation.

Review

On Jan 24th, 2008 the Societe Generale bank of France (a big and old bank) announced that Jérôme Kerviel, a low level futures trader, had fraudulently lost the bank seven billion dollars, the largest such loss in history.

Seven billion... to put that in perspective: the owner of the World Trade Center collected 3 billion in insurance after the 9-11 attack, and a congressional supplemental spending bill for Iraq a couple years ago was a 33 billion dollar bill given to the US taxpayers. Seven billion is a considerable chunk of change.

The interesting part, so far, has been watching the bank squirm as it tries to explain this. It is the bank's clumsy squirming that signals a Panic is in progress.

To review a little more:

Roger's definition of a Panic is when the brain seizes up and stops thinking well because it is faced with a situation that is both novel (as in never experienced before) and scary. This can happen to an individual, or to a whole community.

When Panic happens, it is often followed by a Blunder. A Blunder is an action taken to solve a Panic. It is an action that looks very good and very logical to do at the time of the Panic by those involved in the Panic, but in retrospect (and to 'coolheaded' outsiders at the time) it looks both silly and very, very expensive. Note that a Blunder is an emotionally charged choice, so people who make a Blunder will often believe that the blunder was a correct action for years after its errors become obvious. An example of believing in a blunder for years after is the Boston response to the Cartoon Sign Bomb Scare of January 2007.

My favorite example of a Panic-leading-to-Blunder situation is Bush deciding to attack Iraq. The decision to attack was a Blunder induced by the 9-11 Disaster Panic.

Back to the present: the surprise loss of seven billion is certainly a novel situation. Banks sometimes lose billions, but they usually know it's happening weeks to months to years before it happens. In this case, the loss happened over a few months, and the managers who had to report it to the public after it was discovered had to report on it just days after it was discovered. The story is that they confronted Kerveil on January 19th, and issued their press release to the public on January 24th. They de facto had no warning, which makes this a novel situation.

Having the loss happen because of the actions of a low-level employee is really scary. If one such employee could do this, how many hundreds or thousands of others could be doing it? This is the really scary part.

So, in this situation we have novel plus scary... we have sufficient grounds for Panic.

Has the Panic happened?

Has the Panic happened?

One of the first signs that the bank is panicked is reading their early press announcements about what has happened. They couldn't decide how to "spin" this disaster or their portrayal of the man at the center, Jérôme Kerviel. Early on he was described as a low level employee with a weak mind who was a rogue trader. "Oh, and no... our safeguards were good enough that he didn't profit personally from the transactions."

The problems with this description are:

o How could a low-level employee "nuke" the bank for 7 billion?

o If he had a weak mind, why did SocGen hire him as a trader in the first place?

o If he was a rogue trader, how come the bank's safeguards didn't catch him being "rogue" before he did so much damage?

o If he didn't profit personally from these rogue transactions, why did he do them?

This clumsy spinning has lead to one rumor that I've read about already: that the bank is using this crisis to cover-up some Sub-Prime Mortgage losses. Nasty rumors is another sign that Panic is in progress.

This situation is pure panic, and it will be fun to watch. But, it will be expensive, too. With seven billion vaporized, there's a lot of Blundering to be done yet.

-- Cyreenik 

More thoughts on Soc-Gen (Feb 05)

According to the Wall Street Journal article of February 4th, Kerviel started his rogue trading in the summer of 2005, so he has been at this for more than two years before he was revealed. When he was revealed, on January 19th, another trader was sent in to unravel what he had created. That second trader discovered that Kerviel had committed the bank to 55 billion in uncovered trades. (55 billion! That's even bigger than the Iraq War bill!) When he finished unraveling, the result was the $7 billion loss reported in the first press release.

Again, the scariest part of this affair is that Kerviel was not a special employee in any way. This means that thousands of employees at hundreds of banks have the potential to be risking bank money as much as Kerviel did.

This is why there is Panic, and why there will be at least one Blunder coming out of this.

What kind of Blunder can we expect to see?

What kind of blunder can we expect to see?

Kerviel was given the power to nuke the bank because the bank found it profitable to give him the power. As long as he "followed the rules", he collected $70,000 a year, plus benefits, from the bank, and earned the bank enough money from what he did that they felt paying him was worthwhile. Clearly, the equation the bank was using to determine Kerviel's worth did not include a $7 billion hit. But banks around the world have hired thousands of people using a similar mix of giving power and making expectations, so deep changes will have to be made in what bank employees are permitted to risk.

But... the employees were given permission to take those risks because they generated profits. So, short term, cutting employees from the ability to take the futures traders risks that Kerviel was supposed to be taking will cut profits. Banks' bottom lines are going to take a hit over the next year or two as they implement "Anti-Kerviel" policies.

This process of reevaluation of risk is going to be very similar to the reevaluation of risk that had to be done when the Sub-Prime Mortgage Crisis started to ripen. And.... from the looks of it, may be similar in magnitude and location... both are multi billion dollar problems and both are hitting the banking industry.

So, at this stage, I see this Soc-Gen Crisis as one that's going to make the Sub-Prime Crisis look even worse. Here is another place where years of "easy money" has changed how business is conducted, and now we have to figure out how to "do it right", meaning... without so much easy money.

Here is my prediction: The Blunder we are going to see is cutting the ability to take risk too much. We are going to institutionalize our fear of another Kerviel. This is going to cut out some significant benefits to our society.

And, just as the War in Iraq did nothing to save our other skyscrapers from other crazed Muslim terrorists wielding jet planes, the Soc-Gen blunder is not going to address the root issue of this crisis well. The action taken will be viewed as very right by those Panicked, and very silly and expensive by those coolheads around them at the time action is taken, and by everybody but the Panicked People in a few years.

-- Cyreenik

thoughts (1 Feb 08)

more thoughts (5 Feb 08)

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