Who Is Jerome Kerviel?

Includes: DIA, SCGLY, SPY, XLF
by: Eben Esterhuizen

That's probably what the Fed chairman said Thursday 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.

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? Not to mention 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?