Fraud at French bank caused global shock waves
By Nelson D. Schwartz and Nicola Clark Published: January 27, 2008
http://www.iht.com/articles/2008/01/27/business/27socgen.php

PARIS: As panic swept European markets last Monday, word spread that a big hedge fund was in trouble and dumping stocks.

Someone was selling, all right - Société Générale. The French bank was frantically unwinding an estimated $75 billion of bad bets on European stocks that the bank said was placed by a rogue trader, Jérôme Kerviel.

As the bank struggled Friday to determine how someone could have run up $7.2 billion in losses before anyone caught on, the scope - and global effect - of the fraud began to emerge.

From his desk in the middle of the trading floor on the sixth floor of Société Générale's Alicante building in the La Defense business district outside Paris, Kerviel, 31, took huge bullish positions on the Dow Jones Euro Stoxx 50 index and the German DAX in particular, according to a fellow trader still working there who insisted on anonymity.

Société Générale rushed to unwind those trades during the market plunge last Monday, and trading in those futures contracts soared to record levels. The bank's abrupt reversal contributed to a decline that snowballed into an avalanche of sell orders around the world, some traders said. The ensuing turmoil helped prompt the U.S. Federal Reserve Board to make the surprise cut in interest rates announced last Tuesday.

Decoupling: Theory vs. reality

"I have little doubt that Société Générale's unwinding of those positions absolutely pressured indexes worldwide," said Barry Ritholtz, chief executive of FusionIQ, a New York-based investment research and money management firm. "And wouldn't it be embarrassing if the Fed had to make one of the biggest emergency rate cuts ever because of some rogue trader?"

Granted, fears of a recession in the United States and continuing worries about the spread of the subprime mortgage collapse were also responsible for the market downdraft this month. But Ritholtz argued the rapid move by Société Générale to close out tens of billions in futures positions might have been a major factor in pushing an already nervous market into an outright panic.

Ritholtz is not alone in his suspicions.

"I definitely think there is a link," said Byron Wien, chief investment strategist at Pequot Capital Management and a 40-year Wall Street veteran. "This precipitous unwinding created the negative momentum that spread around the world."

Wien also singled out the Fed chairman, Ben Bernanke, for criticism. "Bernanke has been reacting to events, rather than anticipating them," he said.

Last Monday, with U.S. markets closed for Martin Luther King Jr. Day, Ritholtz said, many people on Wall Street were struggling to figure out just why Europe and Asian markets were off so steeply.

"Instant messages were lighting up, and people were saying 'This looks like a big European hedge fund blew up,' " Ritholtz said. Indeed, there was little market-moving data before the plunge.

He was quick to add that the French bank's rapid turnover of the positions assembled by Kerviel would not have been enough to push the German market down 7.2 percent last Monday. But in fast-paced markets, hedge funds and investment firms often pile on once the selling starts. "These things take on a momentum of their own," he said.

Last Tuesday, the volume on the DAX and Euro Stoxx 50 contracts was twice that of open futures contracts, suggesting that the bank was having to sell and then buy back contracts to cover leveraged positions. Ten percent of the volume on DAX futures Tuesday alone was euro9.2 billion.

On a typical day, the total open interest on the Dax futures market is roughly $50 billion, according to Helyette Geman, a professor of mathematical finance at Essec business school in Paris. Although the exact positions are not known at this moment, she said, it was quite likely that Société Générale's trades would have accounted for a major portion of DAX futures activity in recent weeks. She added that settling those positions might have created some downward pressure in the market.

The trader said Kerviel, a member of Société Générale's Delta One team, frequently worked late into the night after other members of the group had gone home. He added that it appeared the pace of Kerviel's trading picked up toward the close of 2007. Many of the trades were placed on near-term futures contracts, the trader said.

Jean-Pierre Mustier, chief executive of Société Générale's corporate and investment banking division, declined to identify which particular indexes formed the bulk of the specious trades, but said during an interview that closing the positions early last week did not cause the steep plunge in markets across Europe.