The $7-billion fraud

January 24, 2008 6:32:31 PM PST
Last Sunday, Societe Generale Chief Executive Daniel Bouton got the call every banking chief dreads.

Undetected by multilayered security systems at the bank, France's second-largest, 31-year old junior trader Jerome Kerviel had for over a year been fraudulently using company funds to bet on European stock markets - wrongdoing that was going to cost the bank billions.

The timing could not have been worse: Stock markets suffered their blackest day since the Sept. 11 terrorist attacks on Monday, meaning Societe Generale was forced to sell the contracts built up by the rogue trader just as bourses were plunging.

It took the bank three days to unload them, and appeared to be the largest trading fraud ever carried out by a single person.

The losses, Societe Generale announced Thursday, amounted to 4.9 billion euros, or more than $7 billion - making it one of history's biggest banking frauds and prompting immediate calls for tighter regulation of the industry.

Societe Generale said Kerviel - described as a "brilliant" student by one of his former university teachers - appears to have netted no personal gain from the scheme.

The trader was compared to Nick Leeson, who bankrupted British bank Barings in 1995. Barings collapsed after Leeson, the bank's Singapore general manager of futures trading, lost 860 million pounds - then worth US$1.38 billion - on Asian futures markets, wiping out the bank's cash reserves. The company had been in business for more than 230 years.

Leeson himself told the British Broadcasting Corp. on Thursday that he was not shocked such a fraud had happened again, but "the thing that really shocked me was the size of it."

Though the scale of losses at Societe Generale is far greater, Bouton insisted that the bank is still financially sound.

The company said it expects to post a net profit of 600 million to 800 million euros ($874 million to $1.16 billion) for all of 2007 - even after the fraud and another 2.05 billion euros ($2.99 billion) lost in the subprime mortgage crisis.

As a result, the bank said it would be forced to raise about $8 billion in new capital, partly by selling shares in a rights offer underwritten by JPMorgan Chase and Morgan Stanley.

Among the many questions were how and why Kerviel perpetrated what the bank described as a fraud "exceptional in its size and nature."

Bouton said the trader's motivations were "totally irrational," netting him no personal financial gains. Three union officials representing Societe Generale employees said managers at the bank who briefed them about the fraud told them Kerviel was having "family problems."

Kerviel, employed by the bank since 2000, had worked his way up from a supporting role in an office that monitors trades to a job on the more glamorous futures desk, where he invested the bank's own money by hedging on European equity market indices - making bets on the future performance of the markets.

Kerviel was involved in what the bank calls "plain vanilla," or the more basic forms of hedging, with limited authority. He took home a salary and bonus of less than 100,000 euros, or about $145,700 - relatively modest in the financial world.

The bank said he went far beyond his role - taking "massive fraudulent directional positions" in various futures contracts, betting at the start of this year that stock markets would rise.

He apparently escaped detection by using knowledge of the bank's control systems gleaned in his earlier monitoring job.

Most of his positions went unnoticed by colleagues and superiors as Kerviel covered his tracks with what the bank described as a "scheme of elaborate fictitious transactions."

He got caught when markets dropped, exposing him in contracts where he had bet on a rise.

Bouton called the fraud "extraordinarily sophisticated."

Jean-Pierre Mustier, chief executive of the bank's corporate and investment banking, said he is convinced Kerviel acted alone.

Analysts were stunned that such a huge fraud could have occurred more than a decade after the one at Barings.

It shows banks "are still under the threat that an employee with a good understanding of the risk management processes can (get around) them to hide his losses," said Axel Pierron, a senior analyst with Celent.

Societe Generale said Kerviel had admitted to the fraud and had been dismissed along with some of his bosses. Bouton offered to resign, but the board rejected his offer.

The bank also filed a legal complaint Thursday accusing Kerviel of fraudulent falsification of banking records, use of such records and computer fraud.

Elisabeth Meyer, Kerviel's lawyer, said on French television network BFM that her client "is not fleeing" and is "available for judicial authorities," but did not specify where he was.

The lawyer said Kerviel had been suspended on Sunday, and was awaiting formal written notification of the suspension.

The Bank of France, the country's central bank, said it was immediately informed of the fraud and was investigating. Its governor, Christian Noyer, said the trader had an abnormal knowledge of Societe Generale's trading systems, and measures would have to be taken to prevent this happening again.

Traders are usually kept to tight spending limits, told "you may trade this much and no more," said Robert Kolb, a professor of finance at Loyola University Chicago. Those controls apparently failed in this case.

Kolb said he expected "a lot of soul searching" in the industry, and predicted that one upshot might be new measures to prevent people who have previously monitored traders later becoming traders themselves.

"It shows that we are in a very troubled period for banks, and I think that it's in such troubled periods that difficult things happen," said Gilles Glicenstein, president of asset management at France's largest bank, BNP Paribas.

Societe Generale's shares, which have lost nearly half their value over the past six months, were suspended in Paris on Thursday morning. They dropped 4.1 percent to close at 75.81 euros ($111.16) after they resumed trading.

Founded in 1864 after a decree signed by Napoleon III, Societe Generale employs 120,000 people in 77 countries.

AP writers Matt Moore in Davos, Switzerland, and Thomas Wagner in London, and John Leicester, Angela Charlton, Angela Doland, Jamey Keaten and Elaine Ganley in Paris contributed to this report.