Inspector Clouseau finds rat at SocGen

ANALYST'S VIEW

The news is still being digested almost a week later: Venerable French bank Societe Generale lost 4.9 billion euros ($7.2 billion) in unauthorized trades by 31-year-old Jerome Kerviel, a junior trader whose job it was to capitalize on small price differences between European equity index futures contracts.

Instead of sticking to his metier arbitrage, Kerviel made one-way bets totaling 50 billion euros on the Eurostoxx, DAX and FTSE futures indexes, a sum so staggering even Inspector Clouseau, the bumbling detective in the Pink Panther movies, would have gotten a whiff of some mischief afoot.

On learning of the "fraud" on January 18, Societe Generale took stock of the losses and blew out the positions on January 21, when the US markets were closed for a holiday, and January 22. (As Clouseau would have said, "This is a very serious matter and everyone is this reuoom is under the suspicions.")

The bank went public with the losses on January 24. Traders are still wondering how much of the market meltdown in Asia and Europe early last week was attributable to the bank's unwinding of these positions.

Societe Generale e-mailed a document to reporters this week detailing the "fraudulent" trades, how they were uncovered and what measures were taken to resolve the situation. "Fraud" or "fraudulent" is mentioned 20 times in the document, just in case anyone was wondering what the bank's stance on the trading losses (victim of fraud) was going to be.

Logically challenged
You've got to hand it to the French for their flair. The title of the document, "explanatory note about the exceptional fraud" is pleasing to the ear, with its nice sense of balance and alliteration (explanatory note/exceptional fraud). The content is less satisfying to our sense of reason. Those with a working knowledge of how the futures business operates are having trouble putting the pieces together.

For example, how did some low-level employee, albeit someone familiar with the bank's "processing and control procedures", manage to elude risk-management systems in amassing such a huge position? The bank says that Kerviel entered fictitious trades to offset his real positions, neutralizing the bank's risk. Fine. But it was still a humongous position for someone earning 100,000 euros a year. ("And what is it yeu deu?")

At the margin
What about his counterparties in the real trades? When a customer trades electronically through a futures' exchange, confirmations are generated automatically by the exchanges "� in Kerviel's case, the Eurex, Europe's largest futures exchange "� and are sent to the clearing firms' back offices.

Once a day (twice at some exchanges), the exchange's clearing corporation reconciles trades to ensure the customers' accounts are fully margined; that is, they have enough cash or securities on deposit with the broker or clearing firm to offset any loss in value of the position.

If the margin is inadequate, the customer can't trade. The broker can liquidate part or all of a position in a matter of hours or days in order to meet exchange-determined margin requirements.

Then there's the small matter of financing. Who provided the funding for Kerviel's trades? The bank would normally finance its employees' positions internally through its treasury or funding desk. Why didn't anyone notice a position of that size? Societe Generale's answers to date have been unsatisfying at best and preposterous at worst.

Questions galore
What's more, if the Eurex was "alarmed by the size of the positions", as French prosecutor Jean-Claude Marin says, why was Societe Generale so blase, accepting explanations from Kerviel rather than looking further? ("This is a door? Yes, I kneow that, I kneow that.")

Market watchers aren't the only, or most important, folks asking questions. The French government wants to know why it wasn't alerted sooner by the Banque de France or financial market regulator AMF. French President Nicolas Sarkozy seems equally unimpressed with Societe Generale's explanation, saying highly paid senior executives should shoulder the blame and face consequences.

Courtesy call
The Federal Reserve, which held an emergency teleconference during the turmoil last week and cut its benchmark rate by 75 basis points before the stock market opened on January 22, must be wondering why it was kept out of the loop.

The impairment to Societe Generale's capital from the trading losses, a record for a bank, may not have been sufficient to warrant an official notification to the Fed. Still, as a foreign-owned financial holding company operating in the US, it could have shown its US regulator some respect.

Societe Generale is going to have to do better in explaining how Kerviel managed to "avoid the controls in place". In the past few days we've learned that he had been channeling his inner risk-taker and falsifying trades since 2005, not last year. It makes you wonder what the banks' auditors, both internal and external, were doing. These folks should start readying their resumes.

Before they do, they might want to look over the books one more time. As Clouseau advised, "I suggest you count your bees, you may find that one of them is missing."

(The author is a Bloomberg News columnist. The opinions expressed are her own.)