Sunday, January 27, 2008

Societe Generale's $7.2 Billion Loss: Were the Trades Based on Inside Information?

You probably already know that Societe Generale, the second largest bank in France, announced this past week that it lost $7.2 billion as a result of bad trades in European stock index futures. SocGen ascribed the losses to the "pure fraud" of a lone wolf trader who supposedly worked many extra hours to circumvent the bank's internal controls and undertake unauthorized trades in amounts of tens of billions. Oddly, he didn't personally gain anything from these trades, which initially were profitable, nor did SocGen attribute any motive to him.

Huh? $7.2 billion down the drain with no personal profit or motive? Was the trader involved, identified as Jerome Kerviel, an odd duck who went to great lengths to monkey around with SocGen's computer systems for the sheer thrill of it? He is a single male making an income of $145,000 a year in Paris, the city of lights that draws attractive women from all over France and elsewhere, and all he wanted to do was engage in computer subterfuges so he could trade in esoteric financial instruments for no personal gain?

Okay. And we're the king of England, with a bridge in Brooklyn we'd love to sell you for a very fair price.

Maybe there's another explanation for all this. Maybe someone--or maybe some more than one--at SocGen was trading on inside information.

We all know, especially after 2007, that the stock market is volatile. Anyone who trades stocks would like to have ways to reduce that volatility and increase their chances of profiting. Getting inside information is one of the best ways of boosting your trading returns. It's rather illegal in many circumstances. But that doesn't stop a lot of people. The desire for doubloons trumps fussiness over legalities.

What inside information could SocGen have had? After all, the trading was in futures contracts for European stock indices, such as the CAC 40 and the DAX. It's hard to imagine getting inside information about 40 French or 30 German companies.

But there is one possibility--the European banking authorities and their regulatory intentions. SocGen, like any major bank, would be in constant contact with regulators. The world's banking regulators have worked closely with each other and with the major banks to deal with the subprime mess and the ensuing credit mess. Such a cooperative approach is appropriate and desirable. But the banks would have learned a lot about the regulators' intentions. In the heat of the credit crunch this past year, the regulators may well have wanted to let the banks know that government suppport and assistance would be available 24/7 in generous amounts. While the regulators have also sent the same message to the world, the people working for the major banks would see the facial expressions and hear the vocal intonations of the regulators. They would have had a chance to ask questions and get clarifications, perhaps with winks and nods that neither financial press or any ordinary 401(k) investor in Cubicleville would know about. Maybe SocGen personnel believed they got a better understanding of regulatory intentions than the public markets.

If SocGen personnel came to believe they knew more than the rest of the market, they might have thought that otherwise risky bets in European stock market futures looked like smart plays. Government protection sets a floor on your potential losses. Bigger bets make more sense. Such a scenario could explain why someone at SocGen would choose to trade heavily in large-cap index futures at a time when market volatility was growing. Having inside information emboldens.

If something like this transpired, many questions remain. Did Jerome Kerviel, a junior trader, really perpetrate all this on his own? Who else knew what and when? And was it legal or illegal?

One could also ask whether SocGen's sales last week, undertaken to close out its positions, were unlawful insider trading. The bank, but not the rest of the world, knew about the losses. Ordinarily, under U.S. law, a company having material inside information about itself can't trade in its own stock. The CAC 40, which was apparently one of the stock indices involved in the trading, includes SocGen stock. SocGen constitutes over 4% of the weight of the index, and a significant move in SocGen stock's price might affect the entire index. And if SocGen had disclosed its losses before unwinding any CAC 40 futures positions it held, the index might have lost value for additional reasons (such as the risk of a weakened SocGen to the world's financial system). Maybe there's an insider trading issue here.

More information will probably emerge about SocGen's losses and how they occurred. One thing is clear, though. The losses in the recent financial crisis have mostly occurred in largely unregulated derivatives markets. The stock market, which is heavily regulated, has seen much smaller losses. While Wall Street interests have repeatedly resisted any effort to extend the regulatory umbrella to the derivatives markets, each multi-billion dollar scandal further undermines the argument for leaving the markets alone to work their magic.

Hospitality News: there's a chaplain in the bar. But who would go to a bar where you'd feel like you had to behave yourself?

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