Rogue traders

Barings Bank was the oldest bank in The City at the time Nick Leeson was appointed as its general manager of futures markets on the Singapore International Monetary Exchange (SIMEX). In 1802, Barings helped finance the Louisiana purchase by the US from Napoleon and was Her Majesty's bank when Leeson was part of his staff. He was 25 when he took his seat at the SIMEX and as he started producing huge profits for his bank there, he was given more and more responsability or, said otherwise, less and less supervision over his trade operations. He became a rogue trader, a trader who decides to go on his own and pursue unauthorised operations for his employer. A "trader" is a stock market broker or investor who specializes in short-term conceived transactions. Just for completitude a "future" is a contract for buying or selling an asset in a certain date which is signed before that date arrives and at a price that is fixed at the time of settling the contract. You only pay a percentage of the contract price, as a matter of fact you do not pay but place that percentage as a security deposit, initial margin or performance bond margin, as it is called. Until the delivery date arrives both parts of the contract will have to keep that margin updated. Both the seller and the buyer have deposited the margin. The seller does not even need to own the asset -he can buy it at any time, even at the end of the contract for its current market price- so if the price of the asset goes up he will have to readjust the margin. Assuming that the buyer has deposited money would be naive, fiat money hardly exists in the financial markets: he has most probably deposited some bonds or shares that may vary in value and therefore he has to keep his margin updated, too. The buyer is thus purchasing something, an asset, with money that he does not have to a seller who might not own the asset, but there is more to it: what we have called an asset might not be an asset at all but a commodity, foreign currencies, commercial or government paper, "baskets" of corporate equity ["stock indices"] or any other financial instrument. The obvious consequence of trading futures and other similar financial products is to magnify your market exposure with little money on the hand. Such exposure is sometimes named leverage or gearing.

In China and other neighbouring countries number 8 is supposed to be the foremost lucky number. For example, the International Finance Centre II of Hong Kong, built in 2003, well after Leeson's affair, is quoted as having 88 storeys. It is, however, short of the magic number, due to the fact that "taboo floors" like 14th and 24th etc. are omitted as being inauspicious. Number 14 sounds like "definitely fatal" and 24 like "easily fatal" in Cantonese. Talking about pronunciation, Asians of that linguistic area adopt Occidental names when working for European or American companies so their genuine names are not mispronounced and turned into stupid or again inauspicious words. Local languages are extremely subtle and if you change the music or the entonation of the word, it changes completely. As a matter of fact, the Hongkonese co-workers of Leeson, they all had adopted Occidental names. But the interesting point is that Nick Leeson, wanting to chase good luck, opened an error account with the number 88888, which was supposed to be there to correct and compensate for mistakes made in trading. However, Leeson started losing a lot of money for his bank and hid his losses in that account, which he said belonged to a client external to the bank. By the end of 1992, the account's losses exceeded £2 million, which ballooned to £208 million by the end of 1994. The bank knew nothing about that. Quoting Wikipedia:

"The beginning of the end occurred on 16 January 1995, when Leeson placed a short straddle in the Stock Exchange of Singapore and Tokyo stock exchanges, essentially betting that the Japanese stock market would not move significantly overnight. However, the Kobe earthquake hit early in the morning on January 17, sending Asian markets, and Leeson's investments, into a tailspin. Leeson attempted to recoup his losses by making a series of increasingly risky new investments, this time betting that the Nikkei Stock Average would make a rapid recovery. But the recovery failed to materialize, and he succeeded only in digging a deeper hole.

Realising the gravity of the situation, Leeson left a note reading "I'm Sorry" and fled on 23 February. Losses eventually reached £827 million (US$1.4 billion), twice the bank's available trading capital. After a failed bailout attempt, Barings was declared insolvent on 26 February."

The Dutch group ING bought Barings Bank for £1 and assumed all of Barings' liabilities. This was the first famous case case of a rogue trader but by no means the last one.

The Asian Financial Crisis hit the Far East after the collapse of the Thai local currency, the baht, July 1997, and raised fears of a worldwide economic meltdown. Although there has been general agreement on the existence of a crisis and its consequences, what is less clear is the causes of the crisis, as well as its scope and resolution. I am not saying here that rogue traders did it, of course. They were (and are) just peaks of a multi-head iceberg but they do show the raw materials that finances and their crisis are made of. Toshihide Iguchi was a Japanese government bond trader at Daiwa Bank responsible for $1.1 billion in losses involving 30,000 unauthorized trades over a period of 11 years beginning in 1984. He was born in the city of Kobe, the one which gave its name to the earthquake that finished Leeson off. He was put in jail for that in 1995, just like Nick. Yasuo Hamanaka was the former chief copper trader at Sumitomo Corporation, one of the largest trading companies in Japan. His nicks were "Mr. Copper" and "Mr. Five Percent", because that is how much of the world's yearly supply he controlled. In September 1996, Suminoto Co. disclosed a report acknowledging losses over 2.6 billion dollars due to unauthorized tradings by Hamanaka. Mr. Five Percent was sentenced to prison in 1998. We will skip the cases of John Rusnak (£350 million losses for the Allied Irish Banks in Foreign Exchange options, 2002), Luke Duffy (AU$360 million losses for the National Australia Bank also in FX options, 2004), Chen Jiulin ($550 million losses for China Aviation Oil Corporation Ltd. in Singgapore trading with jet fuel futures, 2005) to talk about Jérôme Kerviel, Boris Picano-Nacci and Bernard Madoff.

Jérôme Kerviel holds the record for rogue trading and he just turned 32 this 11 January. He was responsible for the €4.9 billion losses for his employer, the French bank Société Générale. Kerviel modus operandi resembled Leeson's: he covered losses by saying they were someone else's, namely virtual counterparties, buying time to cover the losses with upcoming trades that he thought would compensate the losses. These fake trades were closed each time in two of three days before they had been formally hedged or before the identity of the broker was known. If they were not compensated by then, new fake trades would serve as new hiding places. The bank said that he was caught because he exceeded the allowed limits with a counterparty whose limits, without him knowing, had recently been changed. Kerviel, in turn, told investigators that such practices are widespread and that getting a profit makes the hierarchy turn a blind eye. The final scene was that Société Générale had losing open positions in the futures market for €30 billion in Euro Stoxx 50, €18 billion in the DAX, and €2 billion in the FTSE 100. Total: approximately a €50 billion exposure that the bank struggled to close between 21 and 23 January 2008. European stock markets suffered heavy losses of about 6% and an the the United States Federal Reserve made an emergency cut in the federal funds rate. Société Générale's investment banking chief, Jean-Pierre Mustier, acknowledged that the three days of forced selling played a role in the market's overall decline, but characterized that impact as "minimal". However, the prices of primary commodities were reaching their highest in history at the time (oil prices surpassed $100 a barrel for the first time, wheat breached the $10 per bushel, corn was trading over $5 per bushel, soybeans traded at $13.42 per bushel, the highest price ever recorded) and this meant huge business opportunities for traders in general, and interesting gambling martingales in the futures market in particular. Meanwhile the Third World was at the edge of starvation, once again. Lone rogue trading is not the cause of all this, of course, but most likely collective rogue finance and trading has quite a few shares in it.

Yet another chapter: In October 2008, in the middle of the financial storm, the French bank Groupe Caisse d'Epargne suffered a €600 million derivatives trading losses and the responsability in it of three rogue traders was partially uncovered. Only the name of Boris Picano-Nacci surfaced.

But if Kerviel is to be placed at the top of the Rogue Trader Premier League, Bernard Lawrence "Bernie" Madoff has the dubious honour of engineering the top financial fraud in history. He is not a rogue trader because he did not hide his rogue operations from his employer, as he was his own employer. Madoff started off by purchasing high-quality ("blue-chip") stocks and then, taking options contracts on them. It seems that he failed in his trading strategies, and to compensate for the losses, he began a client-based Ponzi or pyramid scheme since at least, 2005. He operated through the Wall Street firm "Bernard L. Madoff Investment Securities LLC", which he founded in 1960 and which was one of the top market maker businesses on Wall Street (the sixth-largest in 2008). It bypassed specialist firms and directly executed orders over the counter (=outside the centralized bourse) from retail brokers. Banks over the world have announced that they have potentially lost billions in dollars as a result. His pyramid scheme was based on the stuff he was an expert, not futures this time, but option contracts and strategies built on them, that we will explain one other day. The New York Post has a list of Madoff's victims in its website here.

Madoff is under house arrest until his indictment, expected in mid-February.

Kerviel is formally charged with the crime of "attempted fraud" but has become the hero of a comic strip that you can buy in Amazon.

Leeson is currently the CEO of the Irish football club Galway United.

Update (6/2/09): Unfortunately, I will have to keep rewriting this post. Just today the Wall Street Jounal says on its fron page: Deutsche Bank Fallen Trader Left Behind $1.8 Billion Hole. His name is Boaz Weinstein, he seems to have been playing with derivatives, too, and, as he leaves his bank, he is announcing to start up a hedge fund with some ex-colleagues. It might be fun, might it not? Meanwhile, Deutsche Bank reported a net loss of almost €4 billion in full-year 2008, compared with a €6.5 billion profit a year earlier. In particular, its Investments Division is admittedly responsible for a €5.8 billion loss just between October and December last year, according to the financial news agency of Bloomberg L. P.

What is the plural form of bonus?

The Guardian on its front page on 1 November: Rescued bank to pay millions in bonuses.

Royal Bank of Scotland, which is being bailed out with £20bn of taxpayers' money, has signalled it is preparing to pay bonuses to thousands of staff despite government pledges to crack down on City pay.

The bank has set aside £1.79bn to cover "staff costs" - including discretionary bonuses - at its investment banking division for the first six months of the year alone. The same division caused a £5.9bn writedown that wiped out the bank's profits for the same period.

The government had demanded that boardroom directors at RBS should not receive bonuses this year and the chief executive, Sir Fred Goodwin, is walking away without a pay-off. But below boardroom level, RBS and other groups are preparing to pay bonuses to investment bankers who continue to generate profits.

[...]

Several US politicians have seized on an investigation by the Guardian last month which showed six Wall Street banks - Goldman Sachs, Citigroup, Morgan Stanley, JP Morgan, Merrill Lynch and Lehman Brothers - had set aside $70bn (£42.5bn) in pay and bonuses for the first nine months of the year.

Five are in line to benefit from a $700bn US taxpayer bail-out. The sixth, Lehman Brothers, has collapsed - though not without securing considerable bonus payouts for staff in the US.

Quoting Vince Cable, economics spokesman for the Liberal Democrats in the UK: "A complete laissez-faire environment is disastrous". This statement sounds completely at odds with the neoliberalism dogmas awkwardly imported from the US to Europe, primarily by second-row politicians.

Meanwhile, Barclays, second UK's biggest bank, has turned to Middle East investors to bolster its balance sheet and to avoid taking funds from the United Kingdom government’s rescue package. Barclays is raising up to £3.5 billion as a personal investment from HH Sheikh Mansour Bin Zayed Al Nahyan, a member of Abu Dhabi's royal family. Barclays has also turned to sovereign wealth fund Qatar Holding, which will invest £2 billion and has subscribed for warrants to purchase a further £1.5 billion of ordinary Barclays' shares with a fixed price of 197.775 pence per share at any time for a five-year term from the date of issue. Challenger Universal, owned by Sheikh Hamad Bin Jassim Bin Jabr Al-Thani, the chairman of Qatar Holding, will invest a further £300 million.
If all the warrants issued are exercised, Sheikh Mansour will end up with a 16.3 per cent stake in Barclays while Qatar Holding will have 12.7 per cent and Challenger Universal will hold 2.8 per cent of the bank.

Barclays has chosen therefore a different route as the one taken by RBS, Lloyds TSB and HBOS, which on the one hand makes it possible to avoid a ban on executives' bonuses, paying dividends and a demand to increase lending to small business and would-be home owners. On the other hand, the deals are not cheap for the bank and the existing common shareholders. The deal hinges on two main financial instruments: on part of the new funds it will be paying interest at a 14% rate for 10 years on reserve capital instruments dated June 2019 – the highest rate any bank has had to pay for capital- and on the other part it will pay quarterly an annual 9.75% interest rate for mandatorily convertible notes. RCIs are a financial instrument which was authorised as Tier Capital 1 -i.e. capital that together with the shareholders' equity conforms the bank's financial strength from a regulator's point of view- by the Financial Services Authority (FSA), the British financial services industry regulator, based on the Basel Accords, which we will discuss in a later post here in this blog. They are similar to preference shares and carry a coupon of 14%. If this interest cannot be paid, the issuer does not necessarily default: this "fixed dividend" accumulates from year to year. The MCNs will convert into Barclays ordinary shares at a price of 153.276 pence, a discount of 22.5% to the Average Barclays Closing Price. The HM Treasury would have bought the new shares at just above 189p per share and the coupon for preference shares would have been 12%. One important difference lies in the fact that RCIs are tax deductable, whereas a deal with the government would not be. Even if the deal with Abu Dhabi and Qatar seems cheaper under this perspective, it has undermined the important pre-emption rights of existing shareholders as they are only allowed to buy £1.5 bn MCNs out of the total £7.3 bn of the capital raising, and even so you had to be an institutional investor, namely a bank, an insurance company, a retirement or pension fund, a hedge funds or a mutual fund. However, the acceptance of the Treasury's bid would have implied an open scenario for any want-to-be shareholder. This decision proves once again that the free market is not free at all but very much restricted by the interests and bonuses of the bankers.

References: Reference to Barclays' move

Once upon a time there were gold ounces below a dime

It should be time to speak about fractional reserve banking. This is the system that allows commercial banks to create checkbook money, money that has never been issued by the central bank as notes and that only exists in bank's accountancy books. The idea dates back to the time when goldsmiths could store in their safes both the gold used as reference deposits and the notes that were issued on that gold. Assets were correspondingly increased and so was the capacity to pay out new loans, as the volume of deposits was accounted on the basis of the volume of assets, even if these assets are counterbalanced by liabilities.

We can take the example explained in the Workbook on Bank Reserves and Deposit Expansion published first in 1961 by the Federal Reserve Bank of Chicago and subsequently revised a number of times, the last revision being done in 1992 by Anne Marie L. Gonczy. The example starts with someone (agent A) who buys $10,000 of Treasury bills from a dealer in U.S. government securities. Nowadays this means that agent A pays for that securities with an "electronic" check guaranteed by a bank that will call B0. This check is deposited in another account designated by the dealer in another bank B1. Agent A has added $10,000 of securities to its assets, which has paid by creating a liability on its account in B0. We simplify this introductory part of the example by saying that agent A deposits $10,000 cash in bank B1, which is equivalent but simpler (Treasury bills are chosen in that example due to its high liquidity, well, we chose bank notes). Now, banks must maintain reserves in a vault or in the central bank that equal only a fraction of their deposits. This fraction is called reserve requirement or required reserved ratio and it is basically set to 10% in the US and 2% in the Eurozone for most transaction accounts. Reserves in excess of this amount may be used to increase earning assets: loans and investments. If business is active, the banks with excess reserves will probably have opportunities to loan the excess $9,000. As the Worbook states on page 6: "Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrower's transactions accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system". This means that banks do not expect the withdrawal of that money in cash from the final payee of the loan, but to receive a deposit of this payee for that amount. Thus, total assets amount to $19,000 and total liabilities amount to $19,000 as well. However, only $10,000 correspond to fiat money, issued by the central bank. The dealer may come and try to withdraw his or her $10,000 cash, and simultaneously the final payee of the loan may do the same. This potential situation is unlikely to become a problem if we consider a situation in which bank B1 has many customers, both borrowers and depositors. As unlikely as high the percentage defined by the required reserved ratio stands, or the voluntary reserve ratio for those countries where no compulsory one exists (In 1998 the average cash reserve ratio in the UK banking system was 3.1%). This process can go on: B1 can make further loans for the new deposit of $9,000, retaining $900 for its reserve and lending $8,100. We find ourselves in the same situation as before, where both the amount of assets and liabilities rises by $8,100 this time. This procedure converges finally to having $10,000 reserves, $90,000 in loan assets (or investment assets, if we wish) on the one hand and $100,000 liabilities on the other. Banks have created $90,000 which are backed by some secures, theoretically provided by the borrower, if at all. On top of that, interests must be paid by borrowers. However, according to the description of this system, there is not enough money created to pay both the principal and the interest of these loans. In effect, loans repayment means that the corresponding principal, as checkbook money, disappears into thin air but interest must be taken from the deposits of other customers as a return for working hours, for example. This net withdrawal precludes economic growth. Therefore, additional money must be created by new loans so this money gets injected in the system. New borrowers feed prior borrowers in the economy as a whole, like in a pyramid scam.

One would say that this only works if we have just one bank. Well, actually it still works if we have just one big banking system of individual banks interconnected by interbank loans or instruments such as the floating bank notes at an advantageous interest rate, lower than the one applied to external borrowers. The amount of economic activity which can be supported, in the example above, is $100,000 worth since loans and investments are financial negotiable instruments for which banks act as intermediaries. This is why banks are such an important player in our economy, they decide how much economic activity takes place, i.e. how goods are produced and distributed and how much we consume again as goods or as services. And this is why governments are bound to help them not to default. If they defaulted, ecomony as a whole would collapse.

After World War II, the Bretton Woods system was in some sense a come back to the Gold standard as it obliged each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and gave the IMF the ability to bridge temporary imbalances of payments by carrying out gold reserve exchanges or by loans. This system collapsed when the United States government decided to end the convertibility of the US dollar for gold in 1971. Nowadays, the reference -at least in theory- is the fiat money, not the gold, i.e. banknotes backed by central banks as an instrument of payment. Yet, other finantial instruments have come along that are starting to lose its meaning in terms of fiat money, just as banknotes lost its reference to gold in the past. These financial instruments stem from loans as explained above, but not only from them. Loans and investments have given birth to other generations of financial products (derivatives, structured finance instruments, hedge funds, etc) to become a family that is becoming more and more distant to the actual fiat money whose amount is supposed to be tuned by governments and central banks. Money is therefore created not just by loans but also by these financial engineering instruments.

Floating rate notes. Reading the Wall Street Journal Europe on 27 August 2008

I was flying from Munich airport on 27 August when I was struck by an article on the Wall Street Journal Europe bringing up the issue of the floating rate notes that are due basically now and during the forthcoming fifteen months. It reported about Alex Roever estimates, a J.P. Morgan Chase & Co. analyst who foresaw the credit crunch starting this month, September 2008, when banks were due to pay back $95 billion in floating rate notes. Fannie Mae and Freddie Mac have been both important issuers of these bonds. We know they were placed into conservatorship, a mild word for nationalisation, by the Federal Housing Finance Agency (FHFA) on 7 September.

Fannie Mae (FNMA) was born in 1938 as a government-founded agency as part of Roosevelt's New Deal to provide liquidity to the mortgage market. Until 1968 Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States. That year, and to help balance the federal budget, Fannie Mae was converted to a private corporation. This measure was accompanied with the creation of Freddie Mac and its chartering by the US Congress as a competitor in the secondary mortgage market, so that the actual monopoly would end. Their role was to provide liquidity for what are referred to as conforming mortgages, i.e. mortgages meeting certain minimum standards designed to reduce risk to the lender. Banks and other lenders would be able to sell conforming mortgages to both companies so they could replenish their funds and keep making mortgage loans without worrying about raising money to fund those loans. This way mortgage interest was kept at a much lower rate than it otherwise would have been.

What did Fannie and Fred do with these mortgages? They have been packaging them into the so-called mortgage backed securities and selling them on the secondary mortgage market with a guarantee that the interest and principal would be paid, whether or not the original borrower paid. At least as long as they had the financial solidity to cover these guarantees, of course. In addition to selling mortgage backed securities they also kept a number of mortgages for their own portfolio, which they were funding with a variety of debt securities. In particular they have been important issuers of floating rate notes, a type of bonds usually issued from one bank or financial institution to the other which have a variable coupon or interest given by the federal funds rate in the US or the LIBOR in Europe. All in all, Fannie and Fred were designed to make profit out of:

1. the difference between the interest rate to which they lend money to the original borrower and the interest rate that they write on the aforementioned mortgage backed securities -which is inferior because it is a guaranteed security-,
   
2. the difference between the interest rate to which they lend money to the original borrower and the interest rate that they have to pay to the holder of the debt security with which they fund their portfolio.

However, profit is not a compulsory outcome of the (quasi-) free market and Fannie and Fred have been suffering a negative net growth during the current economic cycle, driven to a large extent by the subprime mortgage crisis. As a consequence of their loss of solidity, liquidity in the mortgage market came to a halt. Also, debt securities issued by these two companies started being scarcely competitive, compared for instance to US government securities. To compensate for this, Fed interest rates are to be cut. Debt securities issued by Fannie and Fred can be found everywhere in the global markets, with a special mention to Chinese banks.

There have also been a few scandals in the management of these two companies that I will analyse in future posts.

What about Europe?
In Europe the main issuers of floating rate notes are banks. The stress they are going through at the moment has to be related to the due date of the floating rate notes mentioned by Mr Roever. The dubious ability of these banks to meet the deadline this month is probably an unconfessed reason because of which the European Central Bank and the national Central Banks are now going to the stake for them. I am afraid they fear the exposure of lack of liquidity of European banks which would spin out of control if savers panic.