Investors’ Regret: Société Générale v Jérôme Kerviel

On 4th July 2008, The Banking Commission of France (BCF) fined Société Générale €403 million euros for the bank’s lack of internal controls in a €4.9 billion trading loss in January 2008.  SocGen blames ‘rogue trader’ Jérôme Kerviel for the loss after it discovered his trading positions on 18th January.  SocGen’s chairman Daniel Bouton also blamed Kerviel for the stockmarket’s 6% fall on 21st January 2008.

Kerviel counter-blames SocGen for its loss, fired his lawyers, and adopted an aggressive stance with a new legal team during a court hearing in France on 23rd July. SocGen had already suffered fallout from the revelations about Kerviel’s losses: Bouton made changes to senior management, and the French bank had to raise €5.5 billion euros to recapitalise, and prevent SocGen from becoming an M&A takeover target.SocGen’s ‘rogue trader’ claim against Kerviel recalls the fate of trader Nick Leeson whose speculation on derivatives and options markets led to the collapse of Baring’s Bank in 1995.  Leeson attempted to trade himself out of bad decisions through his knowledge of exotic options, his control of the settlements role, and his tactical deception using spreadsheet models and accounts with whited-out text that was invisible to others.  SocGen claims Kerviel used complex program trades with exchange traded funds and swaps for a similar tactical deception.  Leeson’s losses made Baring’s illiquid and in 1995 the English merchant bank was sold to ING for £1.

On the surface Leeson and Kerviel share enough similarities as a pair to warrant the ‘rogue trader’ label.  Both had knowledge of sophisticated financial instruments and markets.  Both used this knowledge to make substantial profits for their respective firms.  Both were in teams which faced rapid revenue growth but also with a lack of internal controls: Singapore for Leeson and Delta One for Kerviel.  Both used tactical deception in attempts to escape from adverse trade situations, caused by the misuse of financial instruments, dynamic disequilibriua in the markets, and cascade events.  In Leeson’s case, Japan’s Kobe earthquake on 17th January 1992 was also a Black Swan event.  Both Leeson and Kerviel have made counter-accusations that the banks’ senior management were scapegoating them for larger institutional losses.

One central difference between Leeson and Kerviel is that all game-players are now more aware of ‘rogue trader’ as a media narrative and symbol of financial villains.  Bloggers posted Kerviel’s resume online and registered his name as a website address.  Bouton quickly singled Kerviel out for blame before French authorities also charged Kerviel’s manager. Kerviel countered this with claims that SocGen’s senior management was happy with his trading and that the bank had broader problems with its risk management system.  Independent sites such as ReTheAuditors.com also discussed Kerviel’s case.

SocGen appointed a Special Committee to investigate Kerviel’s trades and to evaluate its corporate governance and risk management systems.  The Special Committee and General Inspection reports found problems with Kerviel which echo post-mortems on Leeson: no supervisor, an inexperienced new manager, problems with intraday positions and high-correlative markets, ignored red flags, and a lack of transparency between middle office and back office functions.  The bank also derisked its internal review by hiring PricewaterhouseCoopers to evaluate SocGen’s risk management systems.  The audit firm then derisked itself by de-scoping its report which PwC claims was based on SocGen’s internal documents and industry best practices.

Was this an exercise in ‘plausible deniability’?  Perhaps.  Did it interest book publishers? Yes, the entrepreneurial small press turned Kerviel’s case into several ‘quick books’ for micro audiences.  Did Kerviel create a new market?  Definately: at a university career fair in May 2008 a Gen Y consultant pitched to me that her Big 4 accounting firm could prevent future Leesons and Kerviels through the automatic control of access rights to critical IT systems.  I countered that whilst this solution would provide audit trails, it might not deal with the ‘human factors’ that allow failures such as Leeson and Kerviel to (re)occur.

CF’s fine signals some deeper problems in SocGen’s corporate governance and risk management systems.  Traders can use knowledge of complex derivatives, options and trading systems for tactical deception.  They may also perceive risk management as a separate function rather than an integral process, although this is changing after the 2007 subprime crisis.  Senior managers who keep changing their stories in a crisis may be stonewalling.  The pressure to make profits can mean that outcomes-based systems are manipulatable according to the outcomes demanded.  In Kerviel’s case managers ignored ‘red flags’ from the Eurex derivatives exchange.  Could Eurex have the independent power to bar traders who reach a high level of ‘red alerts’ in a given period?  What if Eurex took a solution from nuclear detente and have a ‘red phone’ line direct to SocGen’s internal auditors and external regulatory agencies?

Leeson and Kerviel are proof that traders always face the possibility of large losses from consistent market trades.  Fans of Oliver Stone’s film Wall Street (1987) and Michael Lewis’s memoir Liar’s Poker (W.W. Norton & Co., New York, 1989), which is mandatory reading in many MBA corporate finance classes, can overlook this market reality.

But equally overlooked is a more troubling problem: the differences in promotion pathways and work culture between compliance/legal/risk staff and traders who must live by their next deal regardless if the client blows up.  Gordon Gekko (Michael Douglas) recruits Bud Fox (Charlie Sheen) in Wall Street because Fox is ambitious, risk aware, and his working class roots give him a gritty edge.  Lewis suggests in Liar’s Poker that Salomon Brothers traders share a similar outlook.  SocGen’s managers promoted Kerviel to junior trader from a compliance role and SocGen’s lawyers now believes this risk management knowledge aided Kerviel’s tactical deception.  Described by friends as ‘honest, working class’ Kerviel might be Bud Fox without the ‘remorse of conscience’.

Are Financialistas Over Hedge Fund Chic?

You can blame George Soros for making hedge funds the dark horse of the irrationally exuberant 1990s.

As the public face of the Quantum Group of Funds, Soros gained notoriety for short selling the English pound in September 1992 and allegedly making $1 billion in profits.  Adam Curtis observes in his riveting documentary The Mayfair Set (BBC, 1999) that Soros’ victory signalled the first time that market speculators had beaten a country’s central bank.  In the aftermath Soros cultivated a master trader persona based on his personal ‘theory of reflexivity’ or how ‘participant’s bias’ can shape our actions in and perceptions of market events.  Hedge fund chic arose in Wall Street as investment banks rushed to found hedge funds, which use leverage and pooled capital to manage assets, derivatives and securities for an investor group.

Financialistas however are showing signs of buyers’ remorse as subprime turbulence brings an end to Soros-inspired hedge fund chic.  The high-profile collapse of Bear Stearns‘ two hedge funds in mid 2007 was only a precursor, Hedge Fund Research notes, of 170 liquidated in early 2008.  The survivors have adopted Soros’ global macro strategy which relies on computational finance and dynamical models of currencies, interest rates and other macroeconomic factors to achieve returns.

Global macro is a risky strategy for several reasons: it requires forecasting models of complex interactions, computing power and fund mangers with impeccable judgment for asset allocation.  In fact global macro deals with a specific risk class known as systemic risk that results from business cycles and macroeconomic movements, thus it cannot be diversified away.  Add funds’ massive leverage of pooled securities, industry secrecy, little government regulation and hypercompetition between different funds and managers, and an accurate calculation of risk-return is difficult.  These challenges overshadow the potential of applied research solutions, such as Fritz Zwicky‘s morphological analysis, a problem-solving method which deals with ‘multi-dimensional, non-quantifiable problems’ – relevant to the macroeconomic factors and systemic risk in global macro strategies.

Hedge fund chic faces several other problems.  As an investment category hedge funds have matured and their combination of high leverage and high management fees are unsuitable for many non-institutional investors.  Subprime fallout is triggering change in US financial and regulatory institutions which will inevitably lead to more rules and regulatory oversight of edge funds and managers.  Internally, hedge funds also need to separate managerial processes (principal management, portfolio execution) from financial reporting (mark to market book) and governance (board, corporate and policies & procedures).

Which means despite Soros’ alchemical touch hedge fund chic may now be a fad.

Henry Blodget’s ClusterStock

Former securities analyst Henry Blodget recently launched ClusterStock which provides daily news, commentary, and research analysis on the economy, energy, financial services, retailing and technology sectors.  ClusterStock’s parent company Silicon Alley Media appears to follow the Web 2.0 nanopublishing business model of Gawker Media‘s Nick Denton and Mahalo founder and entrepreneur Jason Calacanis.

In a 2008 last-minute submission to Australia’s Review of the National Innovation System I contended that market-based approaches may resolve some challenges in the organisational design and concept to cash/concept to market processes of R&D consortia and institutions.  ClusterStock provides an example for strategic implementation: coverage of market events by sector specialists, near real-time commentary on conference calls, and assumptions testing via reader/user feedback.  The public face provides an information filter and feedback loop in the incubation and idea generation phases of creative innovation.  R&D consortia could implement this web publishing model as a peristyle public face with separate internal processes for ‘commercial in confidence’ information and corporate/government partners.

For his side of the infamous dotcom era blow-up plus an insider’s critique of the investor ecosystem see Blodget’s informative consumer guide The Wall Street Self-Defense Manual (Atlas Books, New York, 2007) and Slate Magazine’s accompanying articles.

Subprime Winners: Rational Herds & Decision Researchers

US capital and derivatives markets in mid-2008 provide a real-time laboratory for behavioural finance analysts who want to understand the madness and wisdom of crowds.  The past week’s case studies include the implosion of the US bank IndyMac and the market volatility triggered by fears that Fannie Mae & Freddie Mac are highly exposed to liquidity risk.

As financial reporter Michael S. Rosenwald notes in The New York Times, these recent events appear to fit the behavioural finance hypothesis that individual investors who make fear-driven and risk-averse decisions can trigger pricing shifts as an aggregate rational herd.  Guillermo A. Calvo and Enrique Mendoza found in a 1997 paper that globalisation counteracts the emergence of rumour markets based on imperfect information and country-specific knowledge, although not in emerging markets due to uncertainties.

However the recent events have different conditions that set delimits on Calvo and Mendoza’s model: the United States is the epicentre of the bear market triggered by the 2007 subprime crisis, Fannie Mae and Freddie Mac have psychological primacy as major financial institutions with US Federal Government backing, and investment media firms such as Bloomberg and CNBC use globalisation to create de facto rumour markets amongst day-traders and others.

Readers interested in rational herds should also check out Christopher P. Chamley’s book Rational Herds: Economic Models of Social Learning (Cambridge University Press, Cambridge UK, 2004), excerpt here.

Decision researchers are the other early winners of the 2007 subprime crisis, due to the failure of many quantitative models to predict the Black Swan event.  Rosenwald mentions Harvard University’s new Bio-Behavioral Laboratory for Decision Science which conducts ‘conducts research on the mechanisms through which emotional and social factors influence judgment and decision making.’  He also refers to the Oregon-based nonprofit group Decision Research.  An Australian-based counterpart might be the Capital Markets CRC, an R&D consortia that focuses on ‘new technologies and improvements in market design’.

Investment analysts still have divergent opinions on recent events.  However the research agenda above prompts several new questions:  What happens to rational herds and rumour markets when bio-behavioural methods of decision-making are no longer ‘imperfect information’ but are widely understood and integrated into investment choices?  How will markets be redesigned to cope with this eventuality, and who will take on this responsibility?  What new financial instruments, markets and products will emerge generativity?

Leximancer’s Customer Insights & Social Media

Leximancer is data mining software that enables you to find statistically significant text patterns in unstructured data.  The software uses a collections/processing approach to gather a cohort of documents, specify filters and rules, run a batch process, and then displays a graphical concept map with causal and statistically significant relationships.  M&A, competitive intelligence, legal and market research teams may find this approach useful for document support.

University of Queensland researchers developed Leximancer, the UniQuest incubator commercialised it, and London’s Imprimatur Capital provided seed capital investment.  The team also recently launched a Customer Insight blog and portal which will explore Leximancer applications in customer experience, surveys and social media.  Its data analytics and statistics capabilities may make Leximancer the evidence-based management solution for those Technorati forecasters who suffer from optimism bias about keywords and the creation rate of new blogs.

Frank Lowy Named In US Investigation on Offshore Tax Havens

The New York Times reports that the US Senate Permament Subcommittee on Investigations named Australian property maven and philanthropist Frank Lowy in a 114-page Staff Report on how the investment bank UBS created offshore tax havens in Liechtenstein.  The report is part of a Permanent Subcommittee investigation on Tax Haven Banks and US Tax Compliance which held a hearing on 17th July 2008.

The Permanent Subcommittee’s press release claims that Lowy used Liechtenstein’s LGT Bank to ‘transfer companies and a foundation with a Delaware corporation to
help the Lowys hide their beneficial interest in a foundation with $68
million in assets.’  NYT reveals the foundation was Laperla based in Liechtenstein and used to funnel up to $US100 million.

The Sydney Morning Herald reports Lowy is cooperating with an Australian Taxation Office audit.  Lowy’s son Peter is rescheduled to appear at a Permanent Subcommittee hearing on 25th July.

The Australian Financial Review‘s forensic journalist Neil Chenoweth investigated Australian entrepreneurs with Swiss offshore tax havens in Packer’s Lunch (Allen & Unwin, Sydney, 2007).  For a broad international context also see my 2006 essay on anti-money laundering initiatives.

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Errors In Quantitative Models & Forecasting

Could the roots of the 2007 subprime crisis in collateralised debt obligations (CDOs) and residential mortgage-backed securities (RMBS) lie in financial analysts who all used similar assumptions and forecasts in their quantitative models?

Barron’s Bill Alpert argues so
, pointing to a shift of investment styles after the 2000 dotcom crash from sector-specific, momentum and growth stocks to value investing.  Investment managers who prefer the value approach then constructed their portfolios with ‘stocks that were cheap relative to their book value.’  In other words, the value investors exploited several factors — the gaps in asset valuation, asymmetries in public and private information sources, price discovery mechanisms and market participants — which contributed to mispriced stocks compared to their true value.

However, the value investing strategy had a blindspot: many of the stocks selected for investment portfolios also had a high exposure to credit and default risk.  The 2007 subprime crisis exposed this blindspot, which adversely affected value investors whose portfolios had stocks with a high degree of positive covariance.

Alpert quotes hedge fund manager Rick Bookstaber who believes that financial engineers have accelerated crises and systemic risks via the complex dynamics of new futures contracts, exotic options and swaps.  These new financial instruments create interlocking markets (capital, commodities, debt, equity, treasuries) which have the second-order effects of larger yield curve spreads and trading volatility.  Alpert and Bookstaber’s views echo Susan Strange‘s warnings a decade ago of ‘casino capitalism’  and ‘mad money’ as unconstrained forces in the international political economy.

Quantitative models also failed to foresee the 2007 subprime crisis due to excessive leverage, difficulties to achieve ‘alpha’ or above-market returns in market volatility, and the separation of risk management from the modelling process and testing.  Other commentators have raised the first two errors, which have led to changes in portfolio construction and market monitoring.  Nassim Nicholas Taleb has built a second career on the third error, with his Black Swan conjecture of high-impact events, randomness and uncertainty (see Taleb’s Long Now Foundation lecture The Future Has Always Been Crazier Than We Thought).

Alpert hints that these three errors may lead to several outcomes: (1) a new ‘arms race’ between investment managers to find the new ‘factors’ in order to construct resilient investment portfolios; (2) the integration of Taleb’s second-order creative thinking and risk management in the construction of financial models, in new companies and markets such as George Friedman’s risk boutique Stratfor; and (3) a new ‘best of breed’ manager who can make investment decisions in a global and macroeconomic environment of correlated and integrated financial markets.

Bryan Burrough on Bear Stearns’ Demise: A Dark Possibility

Bryan Burrough is legendary in M&A circles for co-writing Barbarians at the Gate (Harper & Row, New York, 1990) with John Helyar, the cautionary tale of RJR Nabisco’s leveraged buyout and the winner’s curse faced by deal-maker Henry Kravis.

Burrough’s latest investigation for Vanity Fair contends that short sellers used CNBC and other media outlets to spread rumours that destabilised Bear Stearns and sparked a liquidity run on the investment bank’s capital.  Burrough’s thesis has sparked debate that overshadows his investigation’s strengths: a strong narrative and character portraits, new details of the negotiations with JPMorgan Chase and the Federal Reserve, and a cause-effect arc that shifts from CNBC’s internal editorial debate to the effects its coverage has on the marketplace and the subjective perceptions of individual investors and senior decision-makers.

In the absence of a ‘secret team’ or a ‘smoking gun’ how could Burrough’s thesis be tested?

Theoretically, Burrough’s hypothesis fits with: (1) a broad pattern over two decades of how media outlets respond to media vectors, systemic crises and geostrategic surprises; (2) the causal loop dynamics and leverage points in systems modelling; (3) the impact that effective agitative propaganda can have in psychological operations; and (4) the complex dynamics and ‘strange loops’ in rumour markets (behavioural finance) and rumour panics (sociology), notably ‘information cascade’ effects on ‘rational herds’.

This is likely a ‘correlation-not-cause’ error although it does suggest a dark possibility for strategic intervention in financial markets: could this illustrative/theoretical knowledge be codified to create an institutional capability, deployed operantly, and which uses investor fears of bubbles, crashes, manias and various risk types as a pretext for misdirection?  Behavioural finance views on groups and panics, and George Soros‘ currency speculation against the Bank of England’s pound on Black Wednesday suggest the potential and trigger conditions may lie in the global currency/forex markets (using stochastic models like Markov Chain Monte Carlo for dynamic leverage in hedge funds) and money markets (using tactical asset allocation).  If possible, this capability could also create second- and third-order effects for regulators, the global financial system and macroeconomic structures, and volatility in interconnected markets, which may actually be more dynamic and resilient than this initial sketch indicates.

To meet quantitative standards and validate Burrough’s hypothesis a significant forensic and data analytics capability with error estimates would also be required.  ‘Strong’ proof may not be possible: Burrough’s hypothesis is probably an unsolvable ‘mystery’ rather than a solvable ‘puzzle’ (a distinction by intelligence expert Gregory Treverton that The New Yorker‘s Malcolm Gladwell later popularised).

Ironically, several CNBC analysts have already decided: they used parts of Burrough’s hypothesis to explain the subsequent short-selling driven volatility of Fannie Mae and Freddie Mac‘s stock prices in mid-July 2008.

Jamie Dimon’s Deal & Risk Strategies

Bloomberg Markets‘ Lisa Kassenaar and Elizabeth Hester profile Jamie Dimon the CEO who spearheaded JP Morgan Chase‘s acquisition of investment bank Bear Stearns.

Dimon compares the managerial bias for action and velocity of a pre-deal team to the 101st Airborne Division of the US Army — reminiscent of John Boyd‘s influence on business strategists with his ‘observe-orient-decide-act’ loop used in air combat.  This bias and velocity is crucial for: (1) strategic execution and rollout of high-growth strategy; (2) anticipatory responses to hedging and catastrophic risk; and (3) negotiation in surprise events such as the Bear Stearns collapse.

Dimon focuses on costs in structuring a deal, leveraging strengths and triaging this with risk management and growth strategies that are quickly scalable.  Dimon claims this is why JP Morgan Chase did not venture into the securitisation markets for collateralised debt obligations, subprime mortgages and exotic options.  Instead, his ‘fortress balance sheet’ is ‘defined by efficiency, stable sources of revenue and risk management that protects assets’.  Equally, the risk dimension of ‘risk-return’ is central to banking, securitisation and the leverage of future cashflows.

Kassenaar & Hester’s interviewees suggest Dimon has an ‘information filter’ that oscillates between ‘details’ and ‘the big picture’ to keep track of deals.  In particular, Dimon uses one sheet of paper with ‘things I owe people’ and ‘things people owe me’ rather than a Blackberry.

Dimon’s career management insights: (1) take time off after termination to create a new space; (2) make a financial commitment via an equity stake as a signal to others in your 90-day period to transition-in. Continue reading “Jamie Dimon’s Deal & Risk Strategies”

Harvey Weinstein’s Priority Management

The Village Voice‘s Tony Ortega reveals how uber-media mogul Harvey Weinstein organises his priorities, in-progress projects and key stakeholders:

(1) a “Calls you owe” and “Need to call” daily telephone list
(2) a one-line summary of contactees and their needs
(3) a coterie of personal assistants to handle those sensitive emails

The first two are sparse and remind me of David Allen‘s productivity/workflow heuristics Getting Things Done.

Ortega cites an email to Weinstein by former Weinstein Company employee Lori Sale as a model of succinct communication management:

(1) a one-line summary of the background context for negotiations
(2) the deadline for a decision to be made
(3) the spread of negotiation offers made — with financial details and impact
(4) any counterparty offers and response relevant to (2) and (3)
(5) contact protocol and email signature

M&A communication streamlines (1) – (3) while game theory, negotiation and risk management provide frameworks and methodologies for (4).

Ortega’s garbological adventures to discover Weinstein’s strategies for management (communication,
priority & stakeholders) are on par with
HBO’s Entourage television series on deal-making in Digital Hollywood and Nikki Finke’s blog Deadline Hollywood Daily.