Friday, January 25, 2008

Worse than the subprime mortgage meltdown

Markets and politicians panic about the huge write-offs major financial institutions have to make in the face of this subprime mortgage mess. I am all for market readjustments from time to time. I do not think this one is particularly bad, as it was pretty much expected that subprime mortgages have a higher risk. What worries me more is what just happened in France.

A single broker at Société Générale, a major French financial institution, managed to generate a trading loss of US$7,000,000,000 (seven billions). And according to Société Générale, he did that all by himself. What do I learn from this? That a financial institution that has had a particularly good reputation about its management, audit and control practices could not detect $7 billion being wagered by one of its employees, that no one else knew about it. What about all the other, less reputable institutions? Imagine the risks there.

Now, would this employee just be a scapegoat? If so, this would be a very poor choice by management, as the fact that a single employee can do so much damage shakes my confidence in the institution more than if fraud was committed by several.

Banking circles worry quite a bit about systemic risk. It is time to reevaluate the idiosyncratic risk, especially as it can get into proportions that can measure up with systemic risk.

6 comments:

Acad Ronin said...

Keep in mind that to the degree that the trader lost to other shareholder-owned institutions, and SoGen's shareholders held a well-diversified portfolio, then much of the loss wasn't one. It simply transferred money from their left pocket to their right pocket. The loss to hedge funds, individual futures traders and the like is a loss to the shareholders, but it is not the same sort of loss as having a building collapse. The loss does bring up an interesting question though. How much of the profit of hedge funds and traders is due to the presence in the market of traders who are not constrained to show a profit? If all institutions managed well, could the hedge fund and trading industry continue to exist at the scale and profitiability that it now has?

Independent Accountant said...

I have lived too long. I don't believe for one second his losses were unknown to his supervisors. This guy is just another scapegoat for his higher ups. Like Joseph Jett, among others. The "rogue" trader, is a myth.

Vilfredo said...

I agree that the insistence of SoGen that this trader is the only at fault is the most troubling in this: if true it shows crass incompetence.

I do not agree with the gravity of the situation. While bad for SoGen, the loss itself is diluted within the industry, as someone else must have made a profit.

I am intrigued what this means about the public's confidence in bank management though.

Anonymous said...

This just shows that banks cannot regulate themselves. They should not be allowed to place such risky bets if they cannot even monitor themselves. Banking is largerly based on trust, and it appears one cannot trust them. Reverse deregulation.

Economic Logician said...

Turns out things are even worse. This trader managed to have open positions for US$70,000,000,000, or 50% more than the capital of Société Générale. And nobody noticed...

Independent Accountant said...

Nobody noticed? You may believe it. I don't.