On Warning Signs II: Follow The Money

 As I noted in my last post, On Warning Signs: You Can’t Get There From Here, a failure to inquire into unusual growth in profits, risk, or trading volume is not unique to Jerome Kerviel’s Société Générale experience.  Instead, it is a common pattern across modern rogue trading scandals.

For example, in February 2002, Allied Irish Banks (AIB) -- Ireland’s second largest bank -- disclosed losses of $691 million by John Rusnak, a foreign exchange trader in its Baltimore, Maryland office. AIB took a one-time charge against earnings that eliminated over 60% of 2001 earnings and severely depleted its capital.  Subsequent investigation turned up internal documents indicating that Rusnak was responsible for 95% of the subsidiary’s FX risk and that 80% of Rusnak’s trades were speculative.   Yet such facts failed to prompt inquiry or heightened oversight.

Similarly, as noted in the Price Waterhouse Report prepared for the Singapore Minister of Finance regarding the Nicholas Leeson/Barings Bank debacle:

Mr. Leeson’s product managers accepted the reports of his considerable profitability with admiration rather than skepticism. They perceived no irregularity in Mr. Leeson’s trading activities despite the inherent limit to the profit potential of Mr. Leeson’s arbitrage activities. This was because the price differences that were arbitraged were small, and large volumes had to be transacted in order to realize meaningful gains. However, as the volume of such transactions increased, this tended to reduce the price differences, and therefore the potential profit from arbitrage.

At the time of Barings’ collapse, its positions on the Osaka exchange were eight times greater than the bank’s nearest rival, and its positions on the Singapore exchange were even larger. 

 The most extreme example, however, has to be Joseph Jett at Kidder Peabody. (If you teach only one rogue trading case it has to be this one.  The facts have everything: sexcapades, racial tension, financial shenanigans, and more).  From mid-1991 through the first quarter of 1994, Joseph Jett reported over $264 million in profits from STRIPS trading, supposedly earned through arbitraging small differences between the trading prices of U.S. government bonds and their component STRIPS. 

There’s one problem with this simple story, however.  The market for Treasury securities is highly liquid and actively traded, reducing the potential for arbitrage profits.  Prior to Jett’s employment, the record profit at Kidder for STRIPS trading in a single year was fifteen million dollars.  Jett’s reported profits from STRIPS trading exceeded that amount in a single month four different times.  On a single transaction alone in 1992 Jett recorded an apparent profit of $12.9 million and on another, in 1993, a profit of $24.2 million.  Based on Kidder’s prior STRIPS profitability, such large profits on STRIPS trading would have been unusual for any trader, much less one with Jett’s limited experience in government bond trading and prior disappointing track record.

In reality, Jett’s reported profits were produced through “forward recons” with the Federal Reserve (a non-cash trade of economically equivalent securities, having no real monetary significance, which I describe in more detail here) and a fictitious pyramid scheme enabled by an anomaly in Kidder’s recording and accounting systems that hid Jett’s real trading losses of $74.7 million. By May 1993, Jett’s trades had grown to represent 40–50% of all recon activity in the United States and accounted for 45% of Kidder’s 1993 profits.  His forward recon instructions on some bonds were so large that they exceeded the world-wide availability of the component STRIPS.

In sum, infamous rogue traders don’t typically jump out of the starting gate with large losses.  Instead, they often begin with large gains (Toshihide Iguchi of Daiwa Bank is a prominent exception).  Profitability alone should not, of course, raise risk management suspicions.  But when those profits are improbable relative to the authorized trading strategy, market size, and the trader’s seniority, prior success, and expertise, then it is reasonable to expect some follow-up from risk management and, if necessary, more senior management.

All facts, figures, and calculations used in this post, and the sources and citations from which they are derived, are detailed here.

In my next post, Denial: It Ain’t Just A River In Egypt, I’ll discuss what happened in these cases when skeptics questioned the trading strategies involved.

Image Source Top (Nick Leeson)
Image Source Lower

Related Posts:

Kerviel’s Fake Trades: Genius Or Copy Cat?
Kerviel’s Fake Trades: The Anatomy of A Cover-Up
On Warning Signs: You Can’t Get There From Here
Rogues Versus Scapegoats
Kerviel Trial Opens to Fanfare

Société Générale: Back In The Saddle Again


Jérôme Kerviel to Société Générale: Stand By Your Man

Comments

[Ediberto Roman]

Wonderful post Kim. I have often spoken to my students about the lack of real checks in our regulatory system concerning securities and related markets. The challenge I have often is what to propose as a viable alternative.

Best,

Ediberto Roman

[Kim Krawiec]

Thanks Ediberto. I agree that figuring out how to solve the problem is
much harder than simply pointing out that there is a problem. I
propose a few solutions in my work on rogue trading. Each is
imperfect, but to my mind, far superior to the current regime.