It’s gettin’ so a businessman can’t expect no return from a fixed fight. Now if you can’t trust the fix, what can you trust? For a good return, you gotta go bettin’ on chance, and then you’re back with anarchy. Right back inna jungle.
—Johnny Caspar, Miller’s Crossing
In the midst of massive writeoff & layoff announcements from major U.S. banks, France’s Societe General SA announced a $7.2 billion writeoff (14% of its market capitalization), much of which was blamed on the actions of Jerome Kerviel, a low-level trader who had somehow managed to place $73 billion on stock-market bets (the bank’s market cap is $50 billion). The case is under investigation, and many outsiders are wondering exactly how one “rogue trader” could put that much money at risk.
A lesser-noted aspect of SG’s writeoff is that it also includes $1.6 billion in subprime mortgage exposure, $800 million in U.S. insurance bond exposure, and another $580 million set aside for future liabilities in those two areas. The bank is trying to raise around $8.0 billion in funds through a new share offering. So, sure, SocGen got wrecked by Kerviel’s improper bets, but it also managed to torch itself for almost $3.0 billion in losses based on bets that were perfectly proper.
And that brings me to the topic of risk. A few months ago, I wrote in my magazine (and reposted here) about the subject in light of quantitative hedge funds, subprime mortgages and Hudson Hawk:
Funnily enough, while we’re free of gold, we haven’t gotten over alchemy. Instead of la machina oro, we have “quant funds,” those hedge funds that employ statistical models so sophisticated that they can “find winning trade strategies,” as the Wall Street Journal puts it. From equations to money, like magic!
Turns out one of these winning trade strategies was investing in financial instruments that were based heavily on subprime mortgages (that is, the practice of giving large loans to people who have poor credit). Some of these sophisticated investing models managed to underestimate the risk of — repeat after me — giving large loans to people who have poor credit. [. . .]
Evaluating risk — the true foundation of finance — lost its meaning. For a while.
Now, I know a lot of readers’ eyes tend to glaze over when I try to write about business and/or finance on this site, but I really think
- it’s important that we try to understand the market and governmental forces that shape our day-to-day lives, and
- there are deeper meanings to all this stuff.
In this instance, I’ve been trying to understand what risk is and why the risk management systems at so many financial institutions determined they could afford to take on the investments that have led to billions of dollars in losses.
For instance, an article in the Wall Street Journal (pay-only, I think) discussed the breakdown in risk protection by companies like Citigroup, Merrill Lynch and Morgan Stanley:
“Until recently, every investment bank believed it had built an outstanding risk-management system,” Ken Moelis, former head of investment banking at UBS, wrote in a November letter to his new firm’s investors. Mr. Moelis now runs his own investment bank. “Through computer models and endless analysis, the banks believed they could measure every risk to the nth degree.” But reliance on such models and manuals “overlooked” the importance of “human judgment and the ability to evaluate the numbers being generated,” he added.
Like there’s no interesting metaphor in that? Come on!
Actually, as I did more reading on the subject in the last few weeks, I discovered that a much better writer than I did the heavy lifting for me! Earlier this month, John Lanchester (author of The Debt To Pleasure
Lanchester does a fantastic job of explaining how credit markets work and why they can fail to work. It’s an awfully long piece, but I highly recommend it for a variety of reasons.
In the midst of the article, Lanchester cites writer Peter Bernstein
And I realized that’s where my fascination lies: this idea that the world is knowable.
Whether for the purpose of dismantling fate or “making our fortune,” isn’t that the goal of so much of our art, so many of our sciences?
* * *
Bonus Reading! Joy!
Cityphilia – The article by John Lanchester that kicked this off.
My Theory of Everything – Friedrich von Blowhard on the New Class, which reaps rewards without taking capital risks.
How Real was the Prosperity? – If it turns out that much of the economic growth was based on obviously flawed lending practices, then how real was the money? (Of course, I think about that in a more existential manner than this reporter, but I’m not writing for BusinessWeek.)
Fraud Costs Bank $7.1 Billion – One of the first articles on Jerome Kerviel’s transactions that may or may not sink Societe General SA.
SocGen Had Been Warned About Kerviel – Is 164-year-old SocGen gonna get blow’d up?
Once Again, the Risk Protection Fails – Let’s “manage” “risk”.
Good and Bad Capitalists – Sebastian Mallaby argues that hedge fund managers are more responsible than banks. Go back to Cityphilia and check out the section on Long Term Capital Management.
Tuesday Morning Quarterback – Gregg Easterbrook has a great section on CEO pay, even after companies get rocked for tremendous losses. (Search for the phrase “suppose the general manager”.)
What’s $34 Billion on Wall St.? – In that same vein . . .
French Trader was Forced To Work 30 Hours a Week – The horrible truth on why Kerviel made all those disastrous market bets.
Double-bonus! Now you can buy Jerome Kerviel t-shirts, ladies! 4.9 billion Euros: Respect!Â