My Blog

January 25, 2008

This is a little off my normal beat, but last night just before I left my office I took one last quick look at Bloomberg, and was shocked to see that Société Générale had just announced that a rogue trader had knocked a $7.1 billion hole into its capital base.  Ouch!  This was an astounding loss, and the frantic attempts by Société Générale to close out its huge underwater positions may have actually added to the market panic early this week – one which saw the Fed suddenly cut rates by 75 bps.

The good news is that Société Générale seems to have responded very quickly to the problem.  Apparently the fraudulent trades were first discovered on January 19, and within a week the bank had closed out all the positions as they understood them to be, which is not to say they have discovered all the potential losses – apparently the trader was fairly sophisticated about hiding trades. 

Nonetheless this quick response stands in sharp contrast to the actions (at least insofar as we were able to interpret them) of the authorities here in China when rumors in October 2006 that a trader acting on behalf of the copper reserve fund in China had taken huge trading losses on short copper futures on LME (the initial reports, if I remember correctly, suggested losses of around $500 million).  Rather than immediately close out the losing positions, it seemed that the authorities let them roll over continuously in the hopes that copper prices would soon drop and some of the unrealized losses would be reversed.  That didn’t happen.  Copper prices continued to rise, and it seems that the final losses may have been substantially higher.  How much did the copper fund eventually lose on the position?  Of course we don’t know – state secret.

Although it is hard to get details about the copper trade, it seems that not only did the authorities not immediately close out the position, they may have actually added to their short by selling physical copper out of their reserves in China in an effort to coax spot prices down (and, perhaps, effectively to transfer realized losses from the very visible LME account to a much less visible reserve fund).  In so doing they made two classic risk management mistakes.  First, they made an unwarranted distinction between unrealized and realized losses, wildly hoping that if they did not realize the losses, the losses weren’t real, and if they held on long enough they could even reverse them.  Second, they increased their position in an attempt to gamble their way out of the initial loss.  These are how bad trading losses become trading disasters, and they are classic mistakes of inexperienced traders and risk managers.

It seems that Société Générale understood this and moved quickly to close out the losing position.  Of course I don’t want to praise them too much, given that unauthorized and/or fraudulent trading losses should be discoverable long before they reach the multi-billion dollar mark, still, once they discovered the problem, they moved quickly to limit the loss, unlike the Chinese copper authorities who tried to gamble their way out of it.  If you remember the China Aviation Oil disaster in Singapore the previous year you can pretty much guess that the same thing happened – small losses were hidden and attempts were made to gamble back into profitability.

I think there are two important lessons we should be reminded of from the Société Générale fiasco.  The first is that when things go wrong in the financial markets there is often a tendency for a lot of other seemingly-unrelated things going wrong at the same time.  Just as the French bank seemed to be getting its arms around its sub-prime-mortgage-related losses and the very difficult market conditions of the past few months, it got blindsided by this loss (and I think I remember that a few months ago another large French bank, Crédit Agricole, also reported several hundred million dollars in losses on unauthorized trades). 

This kind of coincidence is usually not a coincidence.  Warren Buffet famously said that it’s only when the tide goes out that you know who is swimming naked, and I suppose it is usually in a crisis that you discover that your risk systems weren’t as good as you thought.  I discussed a somewhat-related topic in earlier blog entries, on the tendency of developing countries in general and China in particular to combine a number of pro-cyclical and self-reinforcing balance sheet mechanisms, so that problems in one part of the balance sheet bring out problems in another.

The second lesson is that a quick, and sometimes brutally firm, response to a financial disaster is, while often difficult to do, the best way to prevent it from getting completely out of hand.  Rather than employ a gradualist approach, or take steps that require at least some good luck in order to be successful, a good risk manager often does best by stepping in quickly and closing down and cleaning up the mess.  Among other things that means that there needs to be a clear incentive for managers not to postpone a resolution – and of course that requires a separation between the execution of a strategy and the risk management function.

Talking about fraud, according to an article in today’s South China Morning Post, China's foreign exchange regulator, SAFE, could liberalize rules allowing firms to buy assets outside the mainland.  Zou Lin, a director in the capital project department at SAFE, was quoted by Shanghai Securities News as saying that SAFE is planning to scrap background checks on companies investing overseas.

At first this seems like an obvious move.  The PBoC is eager to get as much money as possible out of the country in order to help it regain control of monetary policy, and liberalizing the outward investment process is clearly aimed at accelerating cash outflows by making it easier for companies to make acquisitions or investments abroad.

But in fact China has long grappled with corruption, dirty money, and illegal money flows, and what little control the authorities have had is likely to be further eroded by throwing out background checks.  Of course on the other hand China’s informal banking system has done a pretty good job, according to anecdotal evidence, of helping dirty money leave the country, so maybe these new measures will at least bring the illegal flows back into the formal banking system, where they can be measured and monitored.

Comments (13) for "A $7.1 billion loss?"

I'm still not sure why revelations of bad behavior tend to come out at the same time. I agree that it does, and I understand the analogy, but it doesn't really explain in real world terms why. By orgulous - 1/24/2008 10:47 PM

"...they made an unwarranted distinction between unrealized and realized losses, wildly hoping that if they did not realize the losses, the losses weren’t real..." This may have been something other than just a mistake on the part of those responsible for choosing a cleaning-up strategy. Because of the (justified) suspicion of favoritism, nepotism, guanxi, etc., officials in China are typically monitored and evaluated by a set of objective criteria that sometimes create perverse incentives. Such criteria in this case would almost certainly distinguish between unrealized and realized losses, perverse though the results might be, and even though everyone might clearly understand the problem. I heard a similar story on my last visit to China. A major Chinese company, in preparation for listing, was attempting to clean up financial problems in its subsidiaries, several of whom were effectively bankrupt and had outstanding debts that would never be paid. The parent offered the creditor banks a generous settlement, but they typically refused. If they had accepted a settlement, they would have had to show a loss on the loan, and those responsible would have had to face discipline. As long as the loan was outstanding, even if there was no hope of it being paid, there was no need to recognize the loss and put in motion the consequences of recognition. By Don Clarke - 1/24/2008 11:43 PM

Risk Magazine's Equity Derivatives House of the Year: http://www.risk.net/public/showPage.html?page=685494 By Sami - 1/25/2008 4:57 AM

Don, you may be right and that is a pretty common problem, for example with real estate. I have heard that if a building is unable to get tenants at a rent sufficiently high to make the building profitable, the developers would rather leave the space empty than lower the rent and acknowledge that the building was a dud. Among other things this means that overcapacity doesn't necessarily result in lower prices, but rather in empty offices. Orgulous, I guess that when everyone is making money no one is bothering to ask too many questions, but when things get tough suddenly risk aversion rises and people want to understand a particular risk system better. I just read a prepublication copy of Frank Partnoy's book on Ivar Kreuger, and you see after the 1929 crash the number of scandals that emerged shows that this isn't new. By Michael Pettis - 1/25/2008 1:49 PM

Hallo somewhat besides the topic; but .. ft.com: "... Sure, slower international demand will crimp Chinese earnings, and US subprime exposure is (slightly) denting Chinese banks’ balance sheets. But this is small beer compared with issues at home. ..." "..There are plenty of reasons for China’s stock market bubble to implode, but most are internal. .." http://www.ft.com/cms/s/1/c2c5c01e-c996-11dc-b5dc-000077b07658.html One question: a. There are a lot of "home-problems" in China. But these "Problems" are phenomenons in an extemly well running environement (growth ~11.2%); so they are not so big. b. China 07 nominal GDP = 3'195bn and China 07 Exports = 1'222bn and that is = ~38%. If there is a slow down in global demand, there will be a "gigantic double problem" for China. 1. export down 10% means a hard hit in the export-numbers and export-factory-people (and theire relatives, d.i. money trickling into to provinces) and .. 2. export down means also: the "home-problems" of point a. will suddendly find themselves in a very bad environment; and these "home-problems" will explode - in addition to 1. Now the question: How anybody can believe, that the "domestical problems" are the more serious ones? The ft.com "small beer" will be the mother of all beers. globumedes By globumedes - 1/25/2008 7:58 PM

I would be interested in a thoughtful commentary to Thomas Palley's most recent China post: Investing in China: Fool’s Gold? Americans tend to disregard history. Henry Ford declared bluntly, “History is bunk,” while Gore Vidal calls the U.S. “the United States of Amnesia.” Usually, this disregard has few consequences, but sometimes not. That may be so with investing in China, where history suggests profits will be far below expectations, possibly making those investments fool’s gold. China’s history is completely different from that of the United States and it has left deep imprints on China’s politics. Therein lies the trap for investors and policymakers who ignore history and wishfully think market forces will inevitably make China just like the United States. One critical factor is China’s attitude to foreigners. That attitude is captured by the Great Wall of China, which provides a metaphor for China’s long history of isolationism and xenophobia. A second critical factor is the legacy of China’s humiliating defeats in the unjust 19th century opium wars with Great Britain. At the time, Britain was importing large amounts of tea and silks from China, and demanded the right to sell Indian opium in exchange. As the opium trade grew, not only did it cause massive addiction, it also caused a damaging monetary outflow of silver from China. That prompted China to stop the trade, and Britain then turned to military force to keep China’s market open. This historical experience has made China nationalistic and profoundly averse to foreign exploitation, which is why history is so relevant for investing in China. As a result, China will never allow itself to be exploited by foreigners. For investors, the trouble is that China views making profits from the Chinese market as a form of exploitation. When foreign investments are for exports, China has viewed the profits as being earned abroad. Difficulties only arise when the goal is production for the domestic market. This explains why profitability on such investments has historically been so low, and why so-many joint-venture investments with Chinese partners have failed. It also helps explain China’s persistent refusal to enforce foreign owned patents and copyrights that apply to medicines, movies, and music. The lesson is that companies are likely to be disappointed regarding hopes of profiting from China’s massive domestic market. That has special relevance for American banks and insurance companies. China will allow these companies to invest and modernize its financial services infrastructure, but the profit pay-off is questionable. The same holds for auto companies, which China will allow to transfer technology and build modern plants. As long as the production is for export, those plants will be allowed to earn large profits. But once they start selling in the Chinese market, profits will likely shrivel under burdensome restrictions and theft of technology, ideas, and designs. Stock market investors face a different case of fool’s gold, with stock prices being artificially inflated by China’s under-valued exchange rate and capital controls. That makes prices vulnerable to changes of policy. The under-valued exchange rate has contributed to China’s massive trade surpluses, and China has had to buy dollars and sell yuan to prevent its exchange rate appreciating. That has expanded China’s money supply, and Chinese investors have bought stocks to earn higher returns and protect against inflation, which has driven up stock prices. Capital controls have also played a critical role by limiting investments available to Chinese citizens. Since money cannot leave the country, they have been forced to buy local stocks. Hence, the explosive appreciation of the Shanghai stock market, which has spilled into the Hong Kong market. China’s government has profited from this bubble, as it has been able to sell state-owned companies at high prices. Wall Street has also bought into the bubble, telling Main Street investors that the appreciation of Chinese stocks reflects China’s growth prospects rather than its artificial market. However, come the day that China allows external investment by Chinese citizens, Chinese stock prices are likely to suffer as local investors move to diversify outside of China. That potentially makes long-term investing in China’s stock market another case of fool’s gold. The bottom line is that when it comes to China, investors would be wise to remember all that glistens is not gold. By kevinfischer2002 - 1/26/2008 4:04 AM

Hallo kevinfischer "...One critical factor is China’s attitude to foreigners. That attitude is captured by the Great Wall of China, which provides a metaphor for China’s long history of isolationism and xenophobia.." I don't think, that the Chinese-(people)/elits have an isolationsme as a political target. Look at exort-/import numbers, at the Chinese-foreign econ. developpments (Africa, Lat. America, Central-Asia,..; in developped countries: ICBC with 106 overseas branches and 1,165 agents globally (wikipedia), ... "..19th century opium wars with Great Britain.. .This historical experience has made China nationalistic..". What doe's it mean? You can look in allmost any country and you will see, the nationalistc strings are playing in this sense, that every-country says: I first. My interesset first. Some even went to Irak: My security first. .. That is normal. (But hardly sustainable.) Are the Chinese-(people)/elits in an additional way "nationalistic"? This you have to prove by the show of facts; an only naked assertion -and of such size!- is no help. And therfor, because it ist nonsens, it is waste of time to make any further commentary. globumedes By globumedes - 1/26/2008 8:52 PM

Globumedes, I guess it is sometimes tough to make a distinction between domestic and external problems. I would say one of China's biggest problems is its lack of monetary policy (which has led to overinvestment and inflation), but this domestic problem arises because of is foreign currency regime and the large trade and capital account surpluses it runs, which are external issues. China's other big problem, in my opinion, is the weakness of the banking sector and of the financial markets overall, and although these are also largely domestic problems, a slowdown in the external environment could force them into the open. Kevin, I think there is certainly nationalism and ignorance of foreigners in China, but aside from its particular historical circumstances that may be as much a big-country characteristic as anything else. Certainly Americans and Russians (and even Brazilians) can be just as nationalistic and ignorant of foreign conditions. In the case of China sometimes the fact that we are judging a fairly poor, developing country, naturally suspicious of foreign wealth and power, by rich-country standards makes the nationalism seem worse. Still, I have to admit that there is something about the way history is taught in China that is a little disquieting, and I do agree that even among very sophisticated people in China (for example many of my students, who are the top students in the country) there is often a sense that if you make a profit, I must have taken a loss (all games are zero sum). In that case almost by definition foreign profits must come at the expense of the Chinese people, although banker friends tell me that this is a cultural problem common in much of East Asia and is not specifically Chinese. As for the statement that "The lesson is that companies are likely to be disappointed regarding hopes of profiting from China's massive domestic market," that may well be true but not necessarily for specifically China-related reasons – it may have more to do with the quality of expectations. During the 20 years I have been working in the emerging market sector I cannot tell you how many times I have seen wildly over-optimistic expectations turn to disappointment. Developing countries are by definition risky, and China is a big and in some ways very competitive developing country. Some people will make lots of money, but many will be disappointed. By Michael Pettis - 1/27/2008 1:23 PM

This is nothing new but just another bad trader. Unfortunately there are quite a lot of traders, especially young traders under the current trend of banks hiring youngest possible ppl, of this type. And again, the blowup reenforces my belief that banks' risk managers are useless (normally they are incapable of discovering and stopping bad trades that are supposed to be disapproved, but capable of stopping good trades that should go live). I am sure we will see many more blowups of this Kerviel dude type coming in the future, especially when market is at the turning point. What amazes me more is what Kerviel's attorney said: "He's not a robber, he's a good man,'' said Christian Charriere-Bournazel, a lawyer for Kerviel. "The fault was with Mr. Bouton. It was he who decided to unwind these positions.'' How was this moron selected to handle such a big case! By Megatone - 1/28/2008 9:34 AM

I am dismayed to see that the short but controversial article I posted written by Dr. Thomas Palley has been deemed "crap" and "nonsense" by some members. My intention was simply to stimulate a thoughtful discussion on China's willingness to allow foreign companies to profit from its domestic market, not to excite anger or ill feelings. For those of you not familiar with Dr. Palley, he was former Chief Economist with the US-China Economic and Security Review Commission. His CV includes a B.A. from Oxford University, an M.A. in International Relations and Ph.D. in Economics, both from Yale University so his ideas can hardly be dismissed as a "waste of time." While I personally do not agree that China has a history of xenophobia (esp. post Nixon-Mao summit), and will readily concede that many Westerners who believe in China's isolationism typically wrongly point to the construction of the Great Wall in support, whereas its actual purpose arose secondary to intra-Chinese warfare, this does not negate the other points that Dr. Palley makes. I am thankful to Dr. Pettis for bringing up the Chinese belief that for a Western company to "profit" in China's domestic market necessarily requires a corresponding "loss" by the Chinese public. It would be interesting if Globumedes and other native Chinese could take this issue up in greater detail, especially Palley's assertion that Western company profits "will likely shrivel under burdensome restrictions and theft of technology, ideas, and designs" whereas native Chinese companies will be treated much differently. By kevinfischer2002 - 1/28/2008 11:18 AM

kevinfischer2002, i guess in most of the emerging economies, it is very common that people are too afraid of being ripped off by others because ppl becoming rich by ripping off others does happen a lot in these LDCs. so it is not some genuine chinese belief, but some shared characteristic among societies in the similar growth phase. burdensome restrictions are just a form of local protectism, which happens elsewhere too. as a foreign company, that is the fact you gotta live with. also, i cannot agree with your logic that this guy's article is valuable because he went to Oxford or Yale... By Megatone - 1/28/2008 11:57 AM

I have to agree with Kevin on this. Discussions should be conducted with respect. I automatically erase comments that are insulting or otherwise fail to contribute to the discussion. By Michael Pettis - 1/28/2008 3:23 PM

With all due respect, kevinfischer2002, a Oxford / Yale graduate may be a good economist, but it does not make him a good historian, let alone a historian specialized in a specfic country, i.e., China in this case. About the capital control, it has more to do with the need to put foreign reserve together to purchase the most necessary capital goods before 1980. After 1997 Asian Crisis, it was obvious that the very system shielded China from the crisis. That makes this system more difficult to suspend. Your arguement about the stock market is questionable. Before 2004, the stock market was stagnant for several years in China. Remember during that time, China had a lower exchange rate and the same capital control system too. Thus, these 2 policies have little thing to do with the bubble in the stock market. And for IPO issues, it is really just a common practice to issue shares in a bull market rether than a bear market. By fatbrick - 1/28/2008 11:13 PM