PrefBlog

Memorial Day in the US … very little interesting news!

The chatter regarding the SocGen / Kerviel fiasco continues:

“It validates what Jerome has said,” Guillaume Selnet, Kerviel’s defense lawyer, said yesterday in a telephone interview. “The only possible explanation is negligence, individual and systemic negligence.”

The full SocGen report is available via the SocGen Press Releases page. The report itself is illuminating. Essentially, their bookkeeping procedures did not produce exception reporting, or have adequate drill-down capability. Gross incompetence – an accident waiting to happen.

The report, while publicly available, has been encrypted to make extracts hard – I can only imagine they don’t want their various howlers discussed too readily! However, I’ll retype:

Furthermore, the Futures Back Office did not identify the significant frequency of cash complements paid in order to meet deposit requirements as such supervision is not within its mandate. Between January 1 and 18, 2008, in the absence of a sufficient quantity of bonds to cover an IMR requirement undergoing strong growth due to JK’s activities, the Futures Back Office paid a cash complement of over EUR 500 million on five occasions in order to meet deposit requirements, as opposed to one such payment made during 2007 (on March 13, 2007 for a total of EUR 699 million). In the absence of any supervision and of any alert threshold for cash amounts paid as deposits in the procedures in place at that time, Back Office failed to detect the substantial increase in cash payments made under IMR from January 2008 onward. Back Office in fact makes a global cash payment, including by currency and by clearer, other than the deposit paid in cash, margin calls, commissions and interest payments. The controls concern solely any discrepencies between the amounts claimed by the clearer and those calculated by the SG accounting system (GMI/clearer reconciliation). But it is not Back Office’s role to carry out checks on the consistency of the amounts concerned.

Finally, the detailed breakdown of the collateral re-invoicing by GOP, which should have allowed the abnormally high amounts to be identified, was not sent to JK’s direct heirarchal superiors. GOP 2A represented 10% on average of the re-invoicing of the securities deposit financing paid by GEDS to FIMAT Frankfurt since April 2007 (see Table no. 1). This re-invoicing is carried out on a monthly basis by the Securities treasury Middle Office on a pro rata basis in the form of an Excell spreadsheet to the GEDS/TRD manager only (who became GEDS manager on December 18, 2007), i.e. to JK’s L+5, a level which is too high for such data to be analyzed in detail. The DLP and DELTA ONE desk managers (JK’s L+1 and L+2 respectively), who could have identified this significant level of GOP 2A deposit expenditure, directly visible on such re-invoicing statement, were not recipients of this spreadsheet.

In other words, no accountability, no risk management, no brains at all. I’d say the onus is on senior management at this point to show that they should retain their jobs.

Michael J. Orlando, formerly of the Kansas City Fed, has written a piece for VoxEU: Let Form Follow Function: In Defense of Central Bank Independence. Somewhat cursory, but the basic assertion is sound:

Finally, recent events have demonstrated that the Fed may find it necessary to employ new and innovative approaches to target liquidity injections in times of crisis. For example, on December 12 the Fed established a new program to allow discount window borrowers to bid for additional liquidity extended for a fixed period of time. On March 11, the Fed established a program to lend U.S. Treasury securities against a pledge of other, presumably lower quality assets. And on March 16, the Fed initiated another new program to lend directly to primary dealers of government securities. Along with the Fed-arranged marriage between Bear Stearns and JPMorgan Chase, these programs merit continued debate and analysis. However, it is not obvious that the Fed’s ability to respond to this crisis in a timely and effective manner would be enhanced by more immediate legislative or executive oversight.

Willem Buiter disappoints me today with a rather breathtaking “therefore”:

Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.

Dr. Buiter’s policy aim with this recommendation is, I’m afraid, not particularly clear to me. Additionally, I don’t see a lot of support for his premise that authorities are “unable or unwilling … to let large leveraged financial institutions collapse”. One may quibble over definitions, but I don’t think shareholders of Bear Stears are in 100% agreement with this assertion; neither are the beneficiaries of Carlyle’s leveraged mortgage fund or Amaranth – to name but two.

Protect the core, by all means! But to make all financial institutions as safe as the banks would be contrary to the ultimate public good.

Today’s BCE news (hat tip: Financial Webring Forum) is that the Supreme Court will move quickly on the BCE file:

Canada’s Supreme Court has agreed to speed up the process of deciding whether to hear BCE Inc.’s appeal of a lower court decision that threw the company’s $35-billion planned sale to a group of private-equity funds into doubt.

BCE had requested an expedited process to enable the company to try to stick to a plan to close the deal by June 30.

If leave to appeal is granted, the court said it will hear the case starting on June 17, with each side getting one hour for oral arguments.

Such excitement! There’s not just BCE news, but there’s Barry Critchley has asked a rather important question about the David Berry issue (emphasis added):

The current edition of Toronto Life has a major article on Berry that focuses on his time at Scotia — where he was the firm’s highest-paid employee — his $100-million lawsuit against his former employer and regulatory issues he is facing. Berry, his former associate Mark McQuillen and Scotia all faced allegations brought by Market Regulation Services: the latter two settled while Berry opted for a contested hearing.
…
Berry said the settlement materials are relevant and necessary because RS’s Discipline Notices “explicitly states that proceedings in respect of Scotia’s supervision of Berry and McQuillen were not taken by RS.

There is no information, however, that addresses why Scotia was not held responsible for failing to supervise Berry under [UMIR].”

Berry added that “the agreed facts in the settlement agreement entered into between RS and Scotia do not refer to Scotia’s supervisory obligations, and the agreed sanctions represent a simple disgorgement of financial benefits obtained by Scotia through Berry’s trading.”
…
When RS and Scotia settled, RS’s Maureen Jensen said, “We are pleased that Scotia Capital recognized in this settlement that, even though supervision was not an issue, it would not be appropriate to retain profits generated by the wrongdoing of its employees.” Which raises the question: Did Scotia get a special deal from RS?

It should be noted that it’s not too long ago that the Globe was oohing and ahhing over the fat paycheques handed out to dealers’ compliance staff … and RS was very proud of its role as a training ground. Why is revolving-door regulation permitted?

My last major post on the Berry issue was with respect to the OSC decision. There was some more detail given on May 23. Kerviel … Berry … motivations, methods and results were very different. But the basic issue is the same: does management have any responsibility at all to design a risk management system, use it and take responsibility for it? Or is it just there as an after-the-fact ass-covering and blame-casting device?

The market drifted slightly upwards today on light-ish volume.

There were thirteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

A trader at Merrill in London has been naughty, apparently overpricing his inventory by something less USD 20-million. It’s bad news for him, it’s bad news for his supervisor and it’s not all that great for Merrill … but it wouldn’t be news if everybody wasn’t so nervous! Unless more cockroaches scuttle out from under that fridge, I’m inclined to accept their official position:

“The firm routinely reviews the marks our traders set,” Merrill spokesman Jezz Farr said today in an e-mailed statement. “Our preliminary review determined that one desk used marks that appear to be outside of our accepted policy. We have suspended a trader and we continue to review this matter.”
…
“This case shows our oversight system works,” Farr said in the statement, referring to the firm’s detection of the suspended trader’s conduct.

As noted by Calculated Risk, US mortgage delinquencies are rising. I haven’t seen anything yet about whether these increases are sufficiently severe and unexpected to affect credit.

I have made some observations on one of the papers referenced in the Bank of Canada Review : Spring 2008 … you can chase it down through that post.

As noted in a Bloomberg story, the FASB has announced that it:

today issued FASB Statement No. 163, Accounting for Financial Guarantee Insurance Contracts. The new standard clarifies how FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities.
…
Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. It also requires disclosure about (a) the risk-management activities used by an insurance enterprise to evaluate credit deterioration in its insured financial obligations and (b) the insurance enterprise’s surveillance or watch list.

To my mind, the critical paragraphs in the statement are:

25. Expected net cash outflows (cash outflows, net of potential recoveries, expected to be paid to the holder of the insured financial obligation, excluding reinsurance) are probability-weighted cash flows that reflect the likelihood of all possible outcomes. For purposes of this Statement, the expected net cash outflows shall be developed using the insurance enterprise’s own assumptions about the likelihood of all possible outcomes based on all information available to the insurance enterprise (including relevant market information). Those assumptions shall consider all relevant facts and circumstances and, where applicable, be consistent with the information tracked and monitored through the insurance enterprise’s risk-management activities and used to assist in making operational decisions.
…
29. An insurance enterprise shall disclose information that enables users of its financial statements to understand the factors affecting the present and future recognition and measurement of financial guarantee insurance contracts.

It is interesting to consider this change in terms of the Fitch / MBIA battle reported briefly on PrefBlog on March 24, with much better discussion available from Floyd Norris’ NYT blogs If you don’t like your grade, fire the teacher and Jay Brown Keeps Fighting.

FASB Statement 163 seems like a step in the right direction, but whether there will be enough information made available that investors can rationally check the credit ratings is something I have not – yet – seen discussed.

Vallejo has filed for bankruptcy as indicated on May 7. According to Markit 10-Year MCDX closed at 49bp today, essentially unchanged from its opening levels.

And in quite possibly the most astonishing news to hit the street since the last bulletin that the sun rose in the east this morning, SocGen management winked at Kerviel’s trading positions:

Jerome Kerviel was able to amass 50 billion euros ($78.7 billion) in unauthorized futures positions at Societe Generale SA because of fragmented internal controls, a report commissioned by the bank said today.

Kerviel’s supervisors failed to “react in an appropriate manner to several alert signals” and missed at least 1,071 bogus trades, a special committee of the bank’s board found. Unwinding those positions cost a record 4.9 billion euros, the biggest trading loss in banking history.

His supervisors missed the level of his gains, cash flows, brokerage expenses and overlooked warnings from Eurex AG, Europe’s biggest futures exchange, the report said.
…
Kerviel’s manager “tolerated” bets on the direction of index futures and certain equities that were unjustified by his “assignment and level of seniority,” the document said. As a trader on the bank’s “Delta One” desk, his job was to use large volumes to arbitrage small price differences between equity index futures and forwards.
…
In the first three months of 2007, when most of Kerviel’s “massive fraudulent and concealed positions on index futures” were built up, he had no direct supervisor, the report said. His new manager “did not carry out any detailed analysis of the earnings generated by his traders” and received insufficient support from the head of the Delta One desk, the committee found.

Eric Cordelle, who wasn’t identified in the report, was brought in as Kerviel’s direct supervisor in April 2007.

I am unable to determine whether Eric Cordelle went to a good school, or if he’s just another disposable barrow-boy.

The Globe has some more detail:

The internal report, the second published by SocGen into the debacle, said the unidentified assistant had manually entered a large number of fraudulent transactions done by Mr. Kerviel.

It said the assistant registered “several abnormally high intra-monthly provision flows, without having obtained any valid explanations as to their validity.”

It added that the assistant had registered a total of almost 15 per cent of Mr. Kerviel’s fictitious trades.

Thus, they have grounds to pin a big chunk of the blame on a $30,000 p.a. trading assistant … and from the sounds of SocGen’s operation, it wouldn’t surprise me if traders had license to bully the trading clerks. If I remember correctly, that was part of the explanation at RT Capital.

Update, 2008-5-24: Kerviel’s lawyer had a great comment reported in today’s Globe:

* end update.

I will say, however, that SocGen’s new-found frankness is refreshing compared with Scotia’s in the David Berry affair. The OSC has released its reasons for the David Berry decision. Of particular interest is the summary of Berry’s “Scotia Defence”, paragraphs 25-31. Those contemplating a career with a bank are urged to remember that:

• All your actions will be recorded in minute detail
• The bank may, or may not, review these actions
• If the bank needs a scapegoat – or wishes to win a contract dispute – it will find something in the records to hang you with

Preferreds had a good solid day, on what passes in these lackadaisical times for average volume.

There were seventeen other index-included $25-pv-equivalent issues trading over 10,000 shares today.