Thursday, February 28, 2008

Pay Cash, Write Checks, and Save

As the economy slows, wages and salaries stagnate in real terms, and inflation inflates, just about everyone is looking for ways to save money. One simple way is to pay with cash or checks.

Paying cash is painful, because one moment, you had something valuable in your wallet and the next moment it's gone. Your loss of buying power is immediate. You'll think carefully about spending. Using a credit card defers the moment of truth until the end of the month, and even then you can avoid reality by paying as little as 3% of the cash price. Because it hurts to pay cash, you'll spend less.

Cash is also a bother to carry around. You can't carry large amounts conveniently, because retail establishments don't like large bills. And you don't want to carry a lot anyway in case you loss it. When you lose cash, there's no 800 number to call, cancel the cash and get it replaced. You're just out of pocket. So you'll carry less, and spend less.

Paying with checks also inhibits spending. The money goes out of your bank account almost immediately. You'll have to consider whether your monthly budget will survive your splurge. Carrying a checkbook is a bother. If you happen to forget it, well, too bad. You just won't be able to spend, will you?

Of course, you'll wreck the plan if you take cash advances or write checks against a line of credit. Reduce or avoid borrowing. There's a simple reason why banks and retail establishments are so eager to throw credit cards at you--they get richer. But if they're getting richer, by definition you're getting poorer. That's not a good strategy when storm clouds are gathering over the economy.

Animal News: the running of the reindeer. Hemingway wouldn't have written about this.

Tuesday, February 26, 2008

Is the Federal Reserve Pursuing the Wrong Goal?

In the last six months, the Fed has gone from being concerned primarily with easing the credit crunch to avoiding a recession. It has lowered interest rates dramatically, even as inflation statistics reveal a disquieting flareup. Today's wholesale price index showed a 7.5% increase from a year ago. The word "stagflation" reverberates in the punditry.

Since the Fed appears intent on preventing a recession it does not predict, even at the cost of letting inflation get halfway out the barn door, it's worth asking whether the Fed is pursuing the right goal. Recessions, of course, are undesirable. But is the Fed properly giving such a large proportion of its time and attention to this one problem?

While we hesitate to get lawyerly, Section 225a of Title 12 of the United States Code provides that "[t]he Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In other words, the Fed is supposed aim for "maximum employment, stable prices, and moderate long term-interest rates."

This provision of law doesn't say anything about avoiding any and all recessions. Recessions involve some increase of unemployment. Does that mean, however, that the Fed should take out all the stops to prevent a recession, even at the cost of allowing inflation to slip out of control? Hardly. Section 225a lists "stable prices" as a co-equal goal of the Fed. It can't disregard one of its principal legal responsibilities in order to conduct a hot pursuit of another.

Furthermore, Section 225a focuses on the long term. Recessions are a short term phenomenon. Maximizing employment for the long term is best served by keeping inflation under control. Low inflation encourages saving and investment, an industrialized economy's equivalent to plowing and planting. The rapid cheapening of earnings caused by a runaway inflation leads to profligacy and speculation, the antithesis of saving and investment.

Section 225a doesn't require the Fed to promote "full" employment. It uses the term "maximum" employment. The Fed doesn't have to ensure that everyone who wants a job gets one. It is simply obligated to try to promote as much employment as possible, consistent with serving its other goals of stable prices and moderate long-term interest rates.

The last time the Fed chose to make combating recession its principal priority was in the 1970s. We know how that ended: a newly appointed Chairman Paul Volcker had to raise interest rates sharply at the end of that decade in order to quell the inflationary beast, and, in the process, threw the United States into its deepest recession since the Great Depression. He also set the stage for the long period of low inflation and considerable prosperity that we've enjoyed since 1983. An entire generation of Americans has been born and raised to adulthood without experiencing either a bad recession or serious inflation. It's no wonder that so many people think it's okay to have no savings, carry a lot of debt, and buy houses and cars with no money down.

The Fed of the 1970s faced a choice, and tried to have it both ways. In the face of dramatic increases in oil prices and a substantial federal deficit, it tried to stave off recession while letting inflation run riot. The price we eventually paid was severe. Today's Fed faces a similar choice. The advantage it has is the knowledge of what happened in the 1970s. No one wants a return of disco or leisure suits. Even more importantly, no one wants the Fed to take the stern measures Chairman Volcker had to take. Alan Greenspan was very lucky because he got to follow in Paul Volcker's footsteps. Ben Bernanke isn't half as lucky, since he has to follow in Alan Greenspan's footsteps. In a democracy, government officials are tempted to take the easy way out and placate their constituencies. But greatness in government comes from leadership. Abraham Lincoln, Franklin Delano Roosevelt and Winston Churchill didn't placate. They made difficult choices and led. Paul Volcker demonstrated that Fed Chairmen can do the same. What will today's Fed do?

Animal News: police dogs required to wear shoes.

Sunday, February 24, 2008

Auction Rate Securities: the Credit Crunch Hits Main Street

Until recently, the credit crunch largely manifested itself on Wall Street. Banks would be unable to get overnight loans, mortgage lenders would careen towards bankruptcy court, SIVs and conduits--financial creatures of the night that saw the light of day for the first time last summer--would need bank bailouts, and leveraged buyouts of corporations would end up being indefinitely financed by banks that didn't want to be long term investors. People who were trying to buy a house, or to refinance a house, felt the cold wind of the credit crunch. But most Americans weren't trying to buy or refinance a house, and they could concentrate on the World Series and the BCS.

Now, the arcane and obscure from the world of finance, in the form of auction rate securities, have emerged from the swamp to terrify the good citizens of Middletown, U.S.A. To understand auction rate securities, let's take a brief look at corporate finance.

AAA rated corporations can get low cost financing in the commercial paper market. Commercial paper is short term unsecured debt (less than a year in maturity, and sometimes just a week or two) issued by AAA rated corporations. Institutional investors and some wealthy individuals invest in commercial paper. It's often purchased by money market funds. Corporations use commercial paper to finance long term needs, which means that the paper becomes part of an issuing corporation's permanent capital structure. Because short term interest rates are low, compared to the long term returns corporations project from their investment of the funds, borrowing in the commercial paper market can be highly profitable.

However, the short term nature of commercial paper means the issuing corporation must go to the money markets often to roll over maturing paper. When it can't find new investors, the ship hits the sand. That's what happened to some mortgage lenders and SIVs last year. When there is a credit crunch and purchasers for new commercial paper vamoose, the long term nature of the investments made with the borrowed monies makes it difficult to raise funds from asset sales to pay off maturing commercial paper. So the issuers needed bailouts or capital infusions.

Other borrowers wanted access to the low cost financing of the commercial paper market. Among them were muncipalities, other governmental authorities, medical facilities, student loan lenders and nonprofit institutions. Although many of them could borrow long term in the tax exempt markets at favorable rates, short term tax exempt rates are even more favorable much of the time.

The financial engineers on Wall Street saw an opportunity. About twenty years ago, they developed the concept of auction rate securities, which purport to provide long term financing for a variety of non-AAA rate borrowers at short term rates. Sales people like to call this a "win-win" situation. Realists would describe it as hoping to eat your lunch and have it, too.

With auction rate securities, borrowers get a long term arrangement that employs an auction mechanism for re-setting the interest rate at short term intervals, like a day, a week, a month or a few months. At each auction, current holders of the auction rate securities can put them up for sale and new investors (and current holders) can bid to buy them. In this respect, the auction rate securities are little different from commercial paper. If the auction process works as intended, investors get a short term investment they can buy or sell quickly, and the borrower gets long term capital at short term rates.

A problem is that borrowers in this market usually aren't AAA rated. By themselves, they might not be able to attract the auction bids needed to make the process work. In order to gussy them up, underwriters arranged for bond insurance companies to insure auction rate securities. The bond insurers have generally carried AAA ratings. Thus, a guarantee from an AAA rated insurer dolled up the auction rate securities enough to make the auction process work.

Then, a funny thing happened on the way to the forum. The bond insurers began galavanting with CDOs and other denizens of the structured finance markets. These securities were the hotties of the financial markets in recent years. But they turned to be complex, and to have some flaws. Their relationship with the bond insurers went sour as the mortgage crisis emerged. But breaking off the relationship has proven extremely difficult. With a spouse, you can send an e-mail asking for a divorce. With a financial guarantee, though, investors, underwriters, regulators and even a governor might enter the picture.

Because the bond insurers have become imperiled by the mortgage crisis, the auction rate securities they guaranteed have come into question. Even though some major bond insurers haven't lost their AAA ratings, the flow of credit to auction rate borrowers has crunched as auctions have failed. Although the banks that underwrote some auction rate issues provided a degree of support for a while, they now shy away from further aid. The extent of the failed auctions now appears to be around $80 billion and rising (out of a total of around $300 billion in auction rate securities). The banks won't take this bullet for investors.

Many auction rate borrowers are looking for alternative sources of funds to pay off the securities that couldn't be sold at auction. Investors holding those securities are usually getting a higher rate of interest (as a penalty on the issuer for the failed auction). But their holdings can be illiquid, and a bump up in interest rates may be little consolation for loss of access to their capital.

A lot of people in prominent government and private sector positions are now scrambling to shore up the bond insurers. Whether or not their efforts bolster auction rate securities will depend heavily on the terms of whatever bailouts and capital infusions are arranged. Regardless of what is, or is not, accomplished, auction rate securities are an example of how the financial engineers on Wall Street tried to make a higher risk borrower appear to be lower risk, and got too clever by half. There evidently wasn't a Plan B in case the bond insurers lost their AAA ratings, and that rating was the linchpin of the auction process. Maybe there was disclosure to investors about the potential problems if the bond insurer lost its AAA rating. But the consequences to investors don't comprise the entire picture.

There may be significant public consequences from this failure of another Wall Street financial engineering project. As borrowing costs rise for auction rate issuers, public budgets will be tightened up, employees could be laid off, pay raises, bonuses and benefits might be curtailed, and programs may be cut. It's one thing to say caveat emptor to the institutional investors and wealthy individuals who hold these puppies, or to the municipalities and other organizations that issued them. But for the middle and lower income people who now lose pay increases, bonuses, benefits, access to needed public services, or even their jobs, the credit crunch has become a recession or even a depression.

Prominent federal officials continue to issue concerned sounding press releases meant to assure us. But they talk mostly about bandages and emergency back-of-the-envelope measures that would do little or nothing to prevent these kinds of problems from happening again. Preventative measures would require increased regulation, a heresy of the first order in Washington and New York. But to the citizens of Middletown, some change might seem in order.

Sports News: Plus-size men get a chance to be cheerleaders.

Tuesday, February 12, 2008

The Risks of Monetary Policy Based on Perfection

The bursting of the credit bubble has reached beyond subprime loans. Prime mortgage and home equity loan defaults are rising, as are auto loan defaults and credit card defaults. Corporate loans, particularly to the less creditworthy companies, are also showing signs of trouble. Leveraged buyout debt has been orphaned at the banks that provided interim financing. Foreign governments warn of the spreading impact of the U.S. economic slowdown on the rest of the world.

U.S. monetary policy, as implemented by the Federal Reserve, has relied heavily on promoting cheap credit to stimulate economic activity. Easy money encourages consumers to consume, home buyers to buy and home equity borrowers to borrow. Cheap credit also makes dicey business investments look less risky.

The problem, as we now all know, is that cheap credit also encourages risk taking--a lot of risk taking when the credit is really cheap. To make the easy credit monetary policy work, employment levels must stay very high, consumers have to keep consuming more and more, and asset values have to keep rising. In other words, the Fed’s easy credit policy of recent years has been based on everything being perfect. There was no slack. When bad things happened, the financial system took a fright and froze up. It’s still in the process of thawing out, and the prognosis is guarded.

In reality, the Federal Reserve did not ease the market for credit, but disrupted it. It substituted its judgment for what the price of credit should be, in place of the equilibrium the markets would have attained. By making credit really cheap, it laid the foundation for asset bubbles. But when the bubbles burst, what was the Fed’s response? More cheap credit. We are tempted to mumble something here about moving up the learning curve. But sometimes futility is evident.

Dysfunction continues apace in the credit markets. Prices appear lower, but sellers--i.e., lenders--don’t want to sell at low prices. Lower interest rates won’t make a person with no documented income, assets, or employment any more creditworthy. With increased downpayment requirements and other changes in lending standards, the real price of borrowing, if it occurs at all, is rising even as the Fed lowers nominal interest rates. One lesson is that markets try to function even if they are obstructed by government policy. When the government sets an artificially low price for credit, lenders will find ways to raise the real price. That’s sensible from their standpoint but it counteracts the Fed’s intended stimulus.

We know from financial history that the private markets tend to achieve equilibrium through rather volatile and painful processes. The financial panics of the 19th and early 20th centuries are illustrative. It’s in the nature of the political process to try to shift risk and pain onto the government (for both good and bad reasons). The Federal Reserve is today held to a no mistakes, no recessions standard. Given that the financial markets are basically a confidence game anyway, the Fed can’t afford to admit to any weakness, lest it precipitate the mother of all financial panics. It is forced by circumstance to pursue bad options rather than admit it has no good options.

Today’s Fed isn’t aggressive. It’s cautious. In lowering interest rates at the slightest whimper from the stock market or Congress, it’s following a well-trodden path that will be accepted and even applauded by the constituencies with the best access to the press. The fussbudgets and old coots that point to the limited effectiveness of interest rate cuts and their inflationary potential can be ignored (at least for now) amidst the loud acclamation that accompanies any government handout.

Too much is expected of the Fed. It is supposed to maintain the safety and soundness of the banking system, guard against inflation, keep the U.S. economy growing briskly, and allow nary a layoff. The Fed can fulfill these goals only if conditions are perfect. Sometimes, they are. Then again, sometimes, they aren’t. By placing these ultimately conflicting responsibilities on the Fed, we are gradually creating a command and control financial system where the key decisions about price and resource allocation are made by the federal government instead of the collective interactions of the markets. Resource misallocation is inevitable, most recently with too much capital flowing into real estate, commodities (like oil), and the opaque products of financial engineering.

The Fed cannot be all things for all constituencies in the economy. Ideally, it should be responsible only for maintaining the safety and soundness of the banking system, and safeguarding the dollar against inflation. To require the central bank to lay the economic foundation for the entire citizenry's pursuit of happiness is to ask too much.

America will grow comparatively poorer in relation to other nations as its wealth is squandered through government resource misallocation. Many individual Americans today are growing poorer after squandering their wealth in poorly conceived real estate loans. The national impact will follow. You don’t have to take our word for it. Just look at Japan, a country that has gone pretty much nowhere since it misallocated too much capital to real estate and stocks 20 years ago.

Automotive News: the million mile truck.

Monday, February 11, 2008

Home Cooking: Sometimes a Necessity and Always a Virtue

Daily, we endure pundits proferring wheel-spinning arguments about whether or not we are falling or will fall into a recession. The answer won't be known until after the fact, which means that efforts to forestall a recession are a shot in the dark, aimed at preventing something that might or might not happen anyway. Be that as it may, an economic malaise is settling over the land. We rummage around for old sweaters while setting thermostats lower. Vacations are shortened or canceled. Five dollars begins to look kind of expensive for a cup of coffee. Budgets are scrutinized. Lips are pursed. Things begin to look a little grim.

One way to save money while taking some joy in life is to cook at home. The ritual of breaking bread together in the old homestead binds families together, even when the rest of their lives are spent going off in different directions. And the meals, however humble, have a special quality when they're made with your own hands.

The economics of cooking at home are simple. There's about a $10 per meal differential in cost between preparing a dinner at home versus going to an inexpensive restaurant. This differential increases if you like to have a couple of glasses of wine or a couple of beers. But we'll use $10 for the sake of simplicity. If there are two of you, and you have dinner at home 6 nights a week, you'll save about $60 per person times two, or $120 a week. That's equal to about $6,240 a year. Over the course of say, 50 years of adulthood, $6,240 a year totals over $300,000. Save and invest that money, and you could have much more.

If you're not a cook, how do you get started? Today, many people grow up in households where home cooking is more the exception than the rule, and don't get a grasp of the basics. And most boys learn little more than a few hints about grilling steaks and burgers. Cooking seems intimidating if the only vegetable dishes you know how to prepare are ketchup and mustard. Here are a few ideas for getting started.

Begin With Comfort Foods. You'll do best if you begin by trying to cook something that you want to eat often. Comfort foods are usually pretty simple. And you know what the end goal should taste like, so you'll have a much better chance of getting there. This may mean that you start by making mac and cheese, burgers, spaghetti, and omelettes. That's fine. Maybe the nutrition police will scream, but starting off with simple dishes you enjoy is how to build confidence in the kitchen.

Apply the 30-Minute Rule. Don't cook anything that takes longer than 30 minutes. This will keep your ambitions under control. You'll learn simple, basic dishes first. The skills you learn putting spaghetti and salad on the table will get you on your feet as a chef. Then, you can gradually transition to nouvelle this and that.

Choose an Ethnic Tradition. The best dishes are the ones that have been around for many years. Longevity leads to refinement. These dishes tend to come from one ethnic tradition or another. If you have a particular ethnic heritage, look to it for inspiration. You already know how the dishes are supposed to taste. And that's half the game in cooking. Cooking from a recipe is difficult because you're not really sure what you're trying to achieve. But if you grew up eating Mom's goulash, you know what you want. If you don't have any particular ethnic tradition, choose one whose food you like. Ethnic traditions often have a few basic concepts, and build a variety of dishes around the basics. Italian cuisine is based on pasta. Asian cuisines are built around rice and noodles. Northern European cuisines rely on bread and potatoes. Latin American cuisine is based on corn tortillas and potatoes. These basics make cooking, especially under the 30-minute rule, much easier.

Home cooking allows you to indulge in your creative impulses and gives you the satisfaction of feeding friends and family from your own hand. It's more than a way to economize. It's a way of life.

Food News: pancake eating record.

Thursday, February 7, 2008

Love Your Car, Save Money, Send a Kid to College

With real estate values falling, the economy slowing, unemployment rising, inflation threatening and credit drying up, Americans are being forced, to their horror, to save. Painful adjustments are made--less latte, more joe, less dining out, more kitchen time, fewer impulse trips to Paris, more DVD-weekends at home. Hard choices are made between reducing credit card balances and funding college savings accounts for the little ones.

But don't lose hope. There's an easy way to save that's also pretty painless. Just keep each of your cars one year longer than you'd otherwise planned. It will save a fair amount of change, for little trouble on your part.

Let's say you're a car enthusiast and get a new one every three years. We'll also assume that you have the average life expectancy for Americans (somewhere in the mid-70s overall), and that you own cars for about 50 years. A new car every three years means that you'll own about 17 cars over your lifetime. But if you get a new car every 4 years, you'll have about 12 cars. The difference is 5 cars. Most cars depreciate about 50% in the first three years of their lives. Let's assume that you pay an average price of $28,000 for each new car, which is about today's average. You're losing $14,000 to depreciation every time you trade in the old car for a new one. After 5 cars, you've lost $70,000. For the sake of simplicity, we're not factoring the cost of financing or inflation. But they wouldn't change the big picture very much. Owning a car for 4 years means additional depreciation in year 4 of about 10% per car or a total of $33,600. The net savings would be around $36,400.

The $36,400 you'd save would help a fair amount to covering the cost of educating a child in a public university, which is where most kids go to college. And even if you have a gifted child who's headed for a prestigious private college, you'd probably find an extra 36K handy.

What if you already own cars for longer periods of time? If you plan to own your cars for, say, 5 years, then you'd buy 10 over the course of 50 years. But if you held each car for 6 years, then you'd buy only 8 cars over 50 years. Most cars today depreciate about 70% over 5 years. Using our average price of $28,00o for a new car, that's $19,200 of depreciation per vehicle. Buy two fewer cars, and you avoid losing $39,200. Factor in the additional depreciation for year 6 on eight cars, and you'll net about $21,280. Not bad. Do you have an easier way to put together $21,280?

There was a time in living memory when brake pads and mufflers had to be replaced every 15,000 miles. Indeed, many of the cars that the Greatest Generation drove right after returning from WWII needed an oil change every 1,000 miles. By contrast, modern cars are well-built and need much less shop time. They'll almost always go from year 3 to year 4 without giving you much trouble or requiring more than a bit more routine maintenance. In fact, unless you drive 20,000 miles a year or more, going from year 5 to year 6 will often involve only somewhat larger bills for routine maintenance and perhaps new tires.

Very few people will notice whether your car is 3 years old versus 4 years old. Most won't notice if it's 5 years old versus 6 years old. And a lot of the ones who notice won't care. The new car thing is mostly in your head. You buy a new car because it makes you feel better. With the quality of modern cars, you usually won't need a new one for a lot longer than 6 years. At the end of your life, you won't care whether you had a new car every 3 versus 4 years, or 5 versus 6 years. But if your child or children dropped out of college because of lack of funding, you'll lose some peace of mind. Love your car a little longer, save some money, and help your kid finish college.

Legal News: lawyer turns the other cheek.

Wednesday, February 6, 2008

Beware the Price-Earnings Ratio

The price-earnings ratio is a tool for measuring the value of stocks. Take the price of the stock and divide it by the earnings per share. Different industries traditionally have had different p/e ratios. Banks and other financial stocks generally have low p/e ratios. Tech companies tend to have high p/e ratios.

Currently, the p/e ratio for the S&P 500 is around 15. That's low compared to the last ten years. Back in the halcyon days of the dotcom boom, the p/e ratio for the S&P 500 got up to 25 or 30. So is the stock market a good buy now?

The utility of the p/e ratio depends on, among other things, the reliability of the numbers. Price is easy enough to determine. Just look at where stocks are trading. Earnings, however, are a different matter. Earnings are calculations of the companies, and they can get them wrong. Think back to the accounting scandals of the early 2000s: Enron, WorldCom, Adelphia, HealthSouth, and so on. A lot of companies did a lot of restating of their financials. A restatement involves a company's admission that the first time it reported its financial results, it got them wrong. People who traded on the first round of results either paid, or received, the wrong price.

The subprime mess is getting uglier, not prettier, and government investigations are underway. Given the losses that have already emerged, the potential for restatements is nontrivial. Today's p/e ratio could turn out to be an illusion.

Another reason to be careful is that huge losses from the mortgage mess, lbo slowdown, and other secondary and tertiary effects of the foregoing, still seem to lurk in the shadows. A messy situation with bond insurers is lurching around. Banks continue to be stuck with lbo financings. Some ordinary business corporations are recording losses because their cash management investments, of all things, are taking hits from the mortgage mess. No one knows how bad things will get. That's why the Fed keeps dropping interest rates at the slightest whimper from the Street. The Fed is driving through a fog in the middle of a moonless night, without a good idea of the scope of the problem.

These losses not only directly impact corporate earnings. They also create a drag on the economy, and have slowed consumer spending. This will cause more deterioration in corporate earnings. Today's p/e ratio may not hold up, in the near term.

A p/e ratio of 15 isn't bad by historical standards, and if you're investing for the long term (i.e., 10, 20, or 30 years), buying now isn't crazy. That's especially so if you have a regular and disciplined savings program. Don't stop saving simply because the market may be headed south for a while. But be cautious about thinking a p/e ratio of 15 is a bargain. A rising stock market covers up a multitude of sins. A falling stock market will reveal them as the tide pulls back.

Animal News: will roosters be muzzled in Riverside?

Sunday, February 3, 2008

The Societe Generale Scandal: Are There American Jerome Kerviels?

With the recent publicity of a $7.2 billion loss to Societe Generale at the hands of a junior trader, the management and directors of all major banks, brokerage firms and even general business corporations should be asking whether their company has the same problem. All banks and brokerage firms, and virtually all business corporations of any significance, transact in derivatives contracts. These instruments are firmly embedded in modern corporate finance, and may be found in surprising places, like a company's short term investments of its excess cash. The costs of unexpected derivatives risk have been in the limelight since last summer, and the subprime mess illustrates the problems created when you don't understand the risks of the investments you hold. The SocGen scandal, the other hand, exemplifies the dangers of not knowing what your people are up to.

One of the most salient points to emerge from the SocGen scandal is that questions about Kerviel's trading were raised by a third party. As reported by the Wall Street Journal in its February 2-3, 2008 edition (p. A7), Eurex, a European exchange that served as the market for some of the futures contracts Kerviel traded, inquired about his high volume of trades in early November 2007. SocGen's back office supposedly forwarded the inquiry to Kerviel for his response. This, if true, was a crucial mistake. If you ask a potential crook whether or not he's a crook, what kind of response do you think you'll get? (Exhibit A in this respect is the late Richard Nixon.)

When questions are raised about a derivatives employee's trading, other corporate personnel or an outside law firm should do an internal investigation and then respond to the third party. Asking the potential culprit to respond is unlikely to uncover any wrongdoing that might have occurred. Indeed, forwarding the Eurex inquiry to Kerviel for response only fuels suspicions that other personnel at SocGen knew what he was up to, but wanted him to reply so that their involvement would remain obscure.

In endeavoring to confirm an employee's derivatives trading, it is important to go to third parties for information. Don't rely solely on internal sources of information. Computerized surveillance systems are the products of the human mind, and therefore will be imperfect. A computer savvy 31-year old can often outwit the computer-challenged 50-year olds supervising him. If there is a financial institution that served as the counterparty, contact that organization for confirmation (or not) of the trades. If the derivatives contracts were traded on an exchange, documentation either from the clearing agent for the contracts or the broker that supposedly handled the trades, should be sought. Without third party confirmation, you don't know anything for sure.

Another item to look at is cash. Reportedly, Kerviel controlled upwards of 30 billion Euros of contracts that were long the European stock markets (i.e., he thought European stocks would go up). He didn't offset the long position with a short position (which would have been a bet that European stocks would drop). Assuming that a big bank like SocGen can trade these things with 1% down (or 99% margin), Kerviel would have required about 300 million Euros (or close to $500 million) in cash to support his actual long position. Even at a big bank like SocGen, $500 million or so moving to the clearing firm at the behest of one trader, or even one trading desk, is a large enough item that you'd think someone might notice. Perhaps someone did. Perhaps someone knew what he was doing. If SocGen's surveillance systems didn't pick up this kind of cash movement, if Kerviel was able to conceal the movement of this much cash, or if someone was in cahoots with him, then SocGen has some serious improving to do.

Of course, there's the point that Kerviel himself reportedly made. SocGen didn't force him to take much vacation time. It's been long understood within the banking industry that all persons handling cash or other assets should be made to take significant vacations, like two weeks at a stretch. Scams tend to fall apart if no one is around long enough to keep all the necessary balls in the air.

The Jerome Kerviels of the world tend to become emboldened the longer they remain undetected. Banks and other companies must be ever vigilant. However painful these scandals may be, failure to act will only make things worse.

Crime News: a food fight doesn't pay.