On Warning Signs II: Follow The Money

 As I noted in my last post, On
Warning Signs: You Can’t Get There From Here, a failure to inquire into
unusual growth in profits, risk, or trading volume is not unique to Jerome
Kerviel’s Société Générale experience. 
Instead, it is a common pattern across modern rogue trading scandals.

For example, in February 2002, Allied Irish Banks (AIB) — Ireland’s
second largest bank — disclosed losses of $691 million by John Rusnak, a
foreign exchange trader in its Baltimore, Maryland office. AIB took a one-time
charge against earnings that eliminated over 60% of 2001 earnings and severely
depleted its capital.  Subsequent
investigation turned up internal documents indicating that Rusnak was
responsible for 95% of the subsidiary’s FX risk and that 80% of Rusnak’s trades
were speculative.   Yet such
facts failed to prompt inquiry or heightened oversight.

Similarly, as noted in the Price Waterhouse Report prepared
for the Singapore Minister of Finance regarding the Nicholas Leeson/Barings
Bank debacle:

Mr. Leeson’s product managers accepted the reports of his
considerable profitability with admiration rather than skepticism. They
perceived no irregularity in Mr. Leeson’s trading activities despite the
inherent limit to the profit potential of Mr. Leeson’s arbitrage activities.
This was because the price differences that were arbitraged were small, and
large volumes had to be transacted in order to realize meaningful gains.
However, as the volume of such transactions increased, this tended to reduce
the price differences, and therefore the potential profit from arbitrage.

At the time of Barings’ collapse, its positions on the Osaka
exchange were eight times greater than the bank’s nearest rival, and its
positions on the Singapore exchange were even larger. 

 The most extreme example, however, has to be Joseph Jett at
Kidder Peabody. (If you teach only one rogue trading case it has to be this
one.  The facts have everything: sexcapades,
racial tension, financial shenanigans, and more).  From mid-1991 through the first quarter of 1994, Joseph Jett
reported over $264 million in profits from STRIPS trading, supposedly earned
through arbitraging small differences between the trading prices of U.S.
government bonds and their component STRIPS. 

There’s one problem with this simple story, however.  The market for Treasury securities is highly
liquid and actively traded, reducing the potential for arbitrage profits.  Prior to Jett’s employment, the record
profit at Kidder for STRIPS trading in a single year was fifteen million
dollars.  Jett’s reported profits
from STRIPS trading exceeded that amount in a single month four different
times.  On a single transaction
alone in 1992 Jett recorded an apparent profit of $12.9 million and on another,
in 1993, a profit of $24.2 million. 
Based on Kidder’s prior STRIPS profitability, such large profits on
STRIPS trading would have been unusual for any trader, much less one with
Jett’s limited experience in government bond trading and prior disappointing
track record.

In reality, Jett’s reported profits were produced through “forward
recons” with the Federal Reserve (a non-cash trade of economically equivalent
securities, having no real monetary significance, which I describe in more
detail here) and a fictitious
pyramid scheme enabled by an anomaly in Kidder’s recording and accounting
systems that hid Jett’s real trading losses of $74.7 million. By May 1993,
Jett’s trades had grown to represent 40–50% of all recon activity in the United
States and accounted for 45% of Kidder’s 1993 profits.  His forward recon instructions on some
bonds were so large that they exceeded the world-wide availability of the
component STRIPS.

In sum, infamous rogue traders don’t typically jump out of
the starting gate with large losses. 
Instead, they often begin with large gains (Toshihide Iguchi of Daiwa Bank is a prominent exception).  Profitability alone should not, of course, raise risk
management suspicions.  But when
those profits are improbable relative to the authorized trading strategy,
market size, and the trader’s seniority, prior success, and expertise, then it
is reasonable to expect some follow-up from risk management and, if necessary, more
senior management.

All facts, figures, and calculations used in this post, and
the sources and citations from which they are derived, are detailed here.

In my next post, Denial:
It Ain’t Just A River In Egypt, I’ll discuss what happened in these cases
when skeptics questioned the trading strategies involved.

Image
Source Top (Nick Leeson)
Image
Source Lower

Related
Posts:

Kerviel’s
Fake Trades: Genius Or Copy Cat?
Kerviel’s
Fake Trades: The Anatomy of A Cover-Up
On
Warning Signs: You Can’t Get There From Here
Rogues
Versus Scapegoats
Kerviel Trial Opens to Fanfare

Société Générale: Back In The Saddle Again


Jérôme Kerviel to Société Générale: Stand By
Your Man