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The silence of the pundits
French Finance Minister Christine Lagarde said Monday that some internal controls at Societe Generale failed or were ignored before the banking giant announced massive losses attributed to a single trader.
Here is one version of the story. It's gotten plenty of news coverage. It's gotten relatively little pundit coverage. It neither fits the pro-market narrative of one side, nor the "blame it on the Bush administration and deregulation and bad U.S. corporate governance" narrative of the other. By noting the story, and pondering its broader implications ("your favorite hobby horse matters less than you think"), I would like to do my small amount to counteract the silence of the pundits. By the way, I owe this concept to Daniel Klein.
Posted by Tyler Cowen on February 4, 2008 at 07:15 AM in Economics | Permalink
Comments
The story may not fit either narrative that you describe but there are other narratives out there. Here's one. Capitalism, free markets and free trade have enabled unprecedented improvements in human welfare. As a means of organizing an economy, demand economies have demonstrated themselves to be abject failures. Most people accept this yet most associate the benefits of capitalism with the creation of, stuff. Stuff can be lots of things: cars, trucks, software, haircuts, poems, etc. People also recognize that there can be more abstract things that have real value, like insurance. As the complexity of financial instruments and transactions has expanded over the years, they've always been justified as an integral part of the capitalist system. They grease the wheels of the capitalist machine. To disparage them is to disparage the free market itself (consider the rhetoric around the recent proposed tax increase on hedge fund managers).
Yet increasingly, things haven't felt quite right. Blockbuster success is an inevitable aspect of a vigorous free market. People don't begrudge Bill Gates for his billions. He created something (and I say this as someone who largely loathes his software). But there are now whole classes of people who earn staggeringly large amounts for very nebulous activities. This is true of the managerial class (CEO pay anyone? where no failure goes unrewarded) and the financial class. The breathless reports of the Wall Street bonuses boggle minds. And the supposed critical incentive element of the bonuses seem rather dubious when a headline like "Banks reduce bonuses only slightly" appears in yesterday's Washington Post, at the cusp of what looks like the greatest financial debacle in a generation.
This narrative is one in which the SocGen fiasco fits. The notion that Jerome Kerviel accomplished his destruction single handedly, like Nick Leeson before him, seems dubious. Instead, this feels like a symptom of a systemic rot. The LTCM incident, and the way in which it was handled, was another window into the rot. Our economy has evolved into a staggeringly complex entity. This is good. Simple economies are simple because they are dirt poor (literally, recall the Haitian dirt cake story). Yet it feels like this complexity is being exploited by a privileged few who are looting the system; and looting it to a degree that rises well above background noise. Look at Wasserstein's bonus at Lazard, and its size relative to their profits. This looting is defended with idealized paeans to the free market, which all right thinking people support. I'm in the 95th income percentile and all this shocks me. I can't fathom how someone with a median income can view this. It feels like an obscene fraud perpetrated by parasites.
There's a narrative for you.
Posted by: ramster at Feb 4, 2008 10:01:58 AM
In France at least there was some vocal pundit coverage, especially against the "excess of finance". Ségolène Royal was especially lambasted in the French economics blogosphere for calling for the bank to reimburse its clients. Maybe American pundits wisely avoided a topic they dont't understand.
Posted by: Skav at Feb 4, 2008 10:23:44 AM
It isn't just bloggers that largely ignore - it is the entire US media. CNN covers the primaries for endless hours each day but hardly spent any time covering the SG debacle. The primaries are interesting to be sure, but not in my book a minor story by comparison.
There are so may sub-plots here you'd think for sure this MUST make for a great media story: there's personal drama (Jerome now has broad support with many people who note that, unlike Nick Leeson, he did not make money for himself in this); intrigue (rumors that SG tried to hide other losses through this episode); speculation about the future of a huge bank (the likely prospect of SG being broken up into 3 divisions - each taken over by another French bank, BNP Paribas, Credit Agricole + someone else); volumes of analytical stories about corporate governance, financial instruments, regulation, etc. etc.
For all these stories... so little coverage??? I don't get it. At all.
Posted by: sd at Feb 4, 2008 10:32:09 AM
There was a thief. He stole some money from some people who weren't paying attention. He isn't notably different from other thieves that have been around since approximately humans figured out the whole hunting-and-gathering thing. Unless I missed something, there's not a lot of room for decent punditry here, or even news.
Posted by: Dave at Feb 4, 2008 11:07:06 AM
He didn't exactly steal money, borrowing without permission really is the right euphemism here. And he 'borrowed' 50 billion euros. That's a lot more than hunter-gatherers had, in case you hadn't noticed. The mere fact that this is possible is already mind-boggling.
Posted by: GreatZamfir at Feb 4, 2008 11:59:22 AM
The man wasn't a thief he was seduced by the managerial myth that he was in 'control'.
The manager, like the entire managerial rentier class, failed to notice that the workers have to endorse their
managers management. As they own the process they cannot be wrong. So when something does goes wrong it is because of someone's else's failings. They then turn into victims being let down by their employess. It therefore becomes a surprise when an employee fully endorses the management view & wants more than $100K p.a. by manipulating the system
Posted by: ChrisP at Feb 4, 2008 12:01:56 PM
I tend to agree with much of what ramster says. I do think the points about CEO compensation, a topic much discussed here, should be seriously considered by those who see no problem in that area. The same applies to Wall Street bonuses. Indeed, even if some of those bonuses are reasonable in the context of the firms' profits, it's worth asking whether those profits are a reasonable return on the firms' activities or reflect other factors.
As for Kerviel, I suspect, as I do concerning the "rogue traders" who preceded him, that the rogueishness was a little broader than we are told. It is hard to believe that there weren't at least a few people at SG who wilfully looked the other way as all this was going on. Let's remember, too, that rogue traders do not necessarily produce catastrophes. I'll bet more than one has been successful, with his activities remaining unpublicized except for glowing reports about th eprofitability of the trading dept.
Posted by: Bernard Yomtov at Feb 4, 2008 12:11:40 PM
i remeber reading a chicago tribune article when Leeson took down Barings. The reporter interviewed Leo Melamed of the Chicago Mercantile Exch. He said that you don't get large marging deficits at an exchange without exchange officials knocking on doors at an offending institution and that those doors are very high up on the food chain.
the exchange that these trades were made at has said it followed procedure. the most likely scenario here is that bank officials were notified of the position risk and continued to hope that things would just work out. the bank officials need to be more clear about "what did you know, and when do you know it?"
an exchange isn't simply going to send an email to a member's risk department and hope it gets into the right hands. their job as the person guaranteeing counterparty risk is to climb the food chain until they get an answer and $$. this losing position didn't materialize overnight as bank officials have tried to purport. there were likely multiple margin calls met and lots of "hoping it gets better" by bank officials.
people will still trade with bnp tomorrow if the exchange is guaranteeing risk. they won't won't trade at an exchange that does an inferior job of guaranteeing that risk. the offender is bnp and they are covering their you know what.
Posted by: oops at Feb 4, 2008 1:11:02 PM
I don't understand it, but I think the number is too big to be anything but an accident. After you turn over all the rocks, there will be some ugly surprises. This is based simply on intuition. The guy was too low on the food chain, and the idea that he could be just a scapegoat doesn't make sense. This is based on thinking that 'you couldn't make this stuff up.' Any sort of conspiracy would have blown up by now.
The questions that I have is why, since they knew about it over the weekend, their crack derivatives department couldn't have used their knowledge of the situation to unwind things at a lower cost.
As far as real risk, I really don't understand how the trillions in notional value of CDS's are going to work out, since it is enormous and unregulated and we now see just how flawed risk management can be.
Posted by: Zigurrat at Feb 4, 2008 3:24:02 PM
Because it could mean that the subprime mortages are not the cause of the current crisis.Anything that shift the blame from Bush/USA will be ignored .
Posted by: jules at Feb 4, 2008 3:41:26 PM
Dave has a narrative too. It's that JK was just a thief. As it happens, that'll be SocGen's narrative too. And it was Barrings before. As far as LTCM, it's too obscure (outside of finance news geek circles) to merit comment. John Merriwether of LTCM fame is not pumping gas or asking "would you like fries with that" as seems his due given that his abject professional failure nearly precipitated a financial crisis.
These are all just data points. Fleeting glimpses of the reality that hides behind a fog of rhetoric. Why aren't there stories about this? Because the larger subject of economics, finance and markets is incomprehensible to most people. I think I have a pretty good lay persons level of knowledge in this area and still I just don't feel equipped to grasp the complexity or everything from Bretton Woods to CDOs to SWFs to whatever. Everyone has a vague general understanding that these things are all connected and related to how the economy functions, but after that, it just gets to complex. Amidst this complexity, you hear stories of a single young trader losing billions, while a few thousand people at Goldman make billions in boonuses. Apparently one is fraudulent, rogue activity while the other is perfectly normal yet it all looks the same from the outside. And it feels rotten. All these people do is dip their bucket into the money stream as it flows by and pull out their share. They don't actually contribute anything, yet they get paid vastly more than anyone else.
Posted by: ramster at Feb 4, 2008 4:01:16 PM
There is nothing actually very interesting to say. This case is very like the Barings, Daiwa Bank, Sumitomo Corp, and AllFirst cases.
1) The institution gives a relatively junior trader the OK to do some low risk trading, generally involving highly circumscribed position taking.
2) Because it is low risk, it is not very profitable. However, it is profitable enough to lead the institution to permit the trader to take larger positions so that he can generate larger absolute levels of profitability. The institution still believes at this point, correctly or incorrectly, that the risk per dollar of position is slight because the trader has hedges in place.
3) The trader starts to take greater risk by not hedging as much as he ought, and enjoys a run of luck. The trader enjoys the power and prestige that comes from generating profits and hopes to enhance his career. The institution doesn’t notice that the hedging is not up to code because good profits generally draw less attention than equally-sized losses.
4) The exchanges notice this increased volume and notify the institution. The institution replies that they are aware of the activity and that it is entirely within bounds.
5) The trader starts to lose. The trader then has to take bigger unhedged bets because otherwise he can’t hope to win back enough to cover his losses.
6) To buy himself time, the trader hides both the losses and the fact that the hedges are not in place. This requires a great deal of juggling and fiddling of paperwork, so the trader doesn’t dare take a vacation.
7) The institution praises the trader for his profits and his dedication to his job. By now they incorrectly believe his large positions are still very low risk.
8) At some point the trader gives up, or is exposed and the institution determines how much they have lost and whether they are bankrupt (Barings) or not (the others).
There are two simple practices that managements could take that would reduce the likelihood of such incidents. First, since large gain implies large risk, investigate large gains as rigorously as large losses. Second, require all employees to take two continuous weeks of vacation every year.
However, note that to the degree that counterparties to the losing trades are themselves public companies, and to the degree that investors hold well-diversified portfolios, most of the losses simply mean a transfer from each shareholder’s right pocket to their left pocket. Therefore shareholders rightly don’t want the institutions to impose too onerous risk management burdens on their traders.
Posted by: Adrian E. Tschoegl at Feb 4, 2008 4:43:26 PM
Perhaps Parisian arrogance had some role. But of course we are successful. We studied at Ecole together.
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