Who the $*ck is Jerome Kerviel?

That's probably what the Fed chairman said this morning when he woke up and saw the headlines. As it turns out, Jerome Kerviel is a 31 year old Frenchman who enjoys judo and sailing. He worked as a trader at Societe Generale, and somehow managed to lose almost €5 billion in a series of complex, concealed deals on European stock derivatives. Kerviel's colleagues described him as a "computer genius" who was allegedly able to hack into the bank's computers to hide his reckless trading.

The Fed didn't know about Kerviel's shenanigans when they cut interest rates by 0.75% on Monday, and it now looks like the Fed's biggest emergency rate cut ever may have been sparked by a lie. Events unfolded like this: Kerviel screwed up on Friday last week when he failed to disable the bank's automatic alert system and his irregular trading suddenly showed up. Societe Generale's bosses grilled him on Saturday night and the bank's management decided to unwind all the out-of-money trades on Monday. The unwinding of such a massive position put immense pressure on the futures market, and it started looking like a manic Monday. Other traders saw the plunge in futures amid massive and mysterious selling and, even though the U.S. markets were closed for Martin Luther King Day, they start selling everything else.

With U.S. traders away from their desks, the sell orders in an illiquid market caused a bigger than expected shock to prices. There is no doubt that the unwinding of Kerviel's positions contributed in a big way to Monday's dramatic slump in world stock markets. Things got progressively worse in the hours leading up to Tuesday's U.S. market opening, and Bernanke played his ace card, cutting interest rates by 0.75% in an attempt to prevent a stock market meltdown. For more analysis, click here and here.

Some commentators may nominate Jerome Kerviel as the poster boy for everything that is wrong with the Federal Reserve's policies. The Fed has demonstrated by now that they prefer to treat the symptom, and not the cause. Monday's carnage on stock markets was the symptom, and Societe Generale's weak internal control was one of the causes. Cutting interest rates by 0.75% isn't going to stop Jerome Kerviel v2.0 from trying to cheat the system.

Of course, the Fed has little control over the internal controls at banks, but the above example illustrates the futility of treating the symptom instead of the cause. Let's take the cause/symptom analogy a step further. What if the current crisis is merely a symptom of a deeper cause? To quote the legendary investor George Soros:

The current crisis is not only the bust that follows the housing boom [symptom], it's basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency [underlying cause]. Now the rest of the world is increasingly unwilling to accumulate dollars.

If, as Soros argues, the underlying cause of the problem is the end of the dollar's hegemony, then the Fed is doing more damage by treating the symptom, i.e. cutting interest rates to support the stock market. By using aggressive interest rate cuts to shore up stock markets, the Fed devalues the yield advantage of the greenback. Why should other nations hold the dollar as a reserve currency if the Fed shows no restraint in damaging its value? Why should other nations hold the dollar when the Fed is reactive instead of proactive? And let's not even talk about the wave of inflation that will come on the back of the recent rate cuts.

What if every modern day financial crisis is a symptom of a deeper cause? Once again, to quote George Soros:

This is the end of credit expansion [the symptom] based on the mistaken belief of market fundamentalism [the cause], that you should let markets have total freedom.

If you give the market total freedom, you create myriad opportunities for Jerome Kerviel v2.0. I assure you that he is not the only "computer genius" conducting fictitious futures trades to lift bonuses or cover up embarrassment.

How much of the world's derivatives market is fiction?

Disclaimer: I am a George Soros groupie.

Comments

[Fathoms]

It's cocktail hour onboard the Titanic. Shall we jump or wait until the ship sinks far enough that we need merely step off? I weep for future generations. 'Twas greed that killed us all.

[andygaus]

Could someone explain what "unwinding positions" means? I gather it's a mess and you end up losing money, but what does the phrase really mean? Do you renege on transactions, stop further transactions, make compensatory transactions, or what?

[Novista]

This story is changing faster than an exotic dancer's tearaway costumes.

As of yesterday, NYT report, Jerome was up 2.2 billion when the scam was dicovered. Eh?

And those Fed luminaries at the big boardroom table on Sunday night did not even have a single Bloomberg terminal accessible? Pull the other one.

Now, one would ask, of a bank with 52 billion capitalization, how does a rogue trader dump 70 billion on the market, starting small in 2006 and growing ever more confidant?

So SG says, oops, and they interview him on Sunday, or ... was it Saturday ... and let him go ... and the Financial Po-lice raid his flat on Monday except he turned himself in? And this low-level employee was able to circumvent 5 different security firewalls? Right!

Then they unwind his positions and lost c. 5 billion in the process. Let's hear it from Forrest Gump.

[robinhood1]

One news commentator mentioned that the young man did not believe in long vacations. He took all of 4 days off in 2007, in a country where 6 weeks is the norm. Maybe that had something to do with it. The bank I used to work for had a policy of requiring employees to take two weeks off at one time, the better to catch any bank fraud going on. It's hard, but not impossible, to keep a fraud going if you are out of the office for a 2 week stretch.

[mmckinl]

The world's GDP is roughly $50 Trillion ...

There are now well over $500 Trillion worth of financial 'products' being traded out there...

Somethings got to give ... the underlying value of the assets is less than zero.