You will never read a headline that says “Financial Institution Fires Rogue Trader Who Racked Up Massive Gains.” Therein lies the fundamental tension in financial institution risk management. It is not a merely cynical view that financial institutions tacitly tolerate control lapses as long as gains result – indeed, some of the leading commentators place the blame for the current credit crisis squarely under the heading of failed risk management, caused by practices that flourished during years of investment gains.
For example, in a March 11, 2008, Financial Times article (here), one commentator attributes the current crisis to “the biggest failure of ratings and risk management ever.” Similarly, the Seeking Alpha blog, commenting (here) on the contributions that hedge funds have made “to the evaporation of the essential capital equity value of the large financial institutions,” notes that in the lead-up to the current crisis, hedge funds created outsized gains “without managing the risks” and that banks themselves created their own in-house hedge funds to “avoid risk management, technology burden, and regulatory charges.” Many of the recent massive write-downs relate to “devalued subprime assets which had not been monitored properly and which turned out to be cheap due to low risk management standards or lack of risk management at all.”
The most fundamental control weakness may be the system of compensation that rewards risk taking. As noted in a January 28, 2008 Washington Post op-ed column (here), “bankers bet with their bank’s capital, not their own. If the bet goes right, they get a huge bonus; if it misfires, that’s the shareholders’ problem.” CFO.com noted in a March 11, 2008 article (here) that “sidelining caution in favor potential profit is not particularly difficult in a culture built on producer worship.” The CFO.com article goes on to describe practices at various financial institutions that defeated the institutions’ highly touted risk controls.
Within this environment, it is hardly surprising that individuals might feel emboldened to take extraordinary risks, and occasionally produce inconveniently large losses. The infamous case of Soc Gen trader Jérôme Kerviel (discussed previously here) is the best known recent example. An even more recent albeit less spectacular example involved Evan Brent Dooley, who lost $141.5 million for MF Global Ltd. in one day’s wrong way bets on the direction of the price of wheat.
In the February 29, 2008 Wall Street Journal article (here) about the incident, Dooley “blamed the trading loss on the computer he was using. The system ‘failed on a lot of things,’ he said, including problems in ‘settling limits.’” Indeed, the same article quotes MF Global’s CEO as “acknowledging that existing internal controls could have stopped Mr. Dooley’s trades from being processed – but were turned off in a few cases to allow for speedier transactions by brokers at the firm who traded for themselves or took customer order by phone.”
Large losses often produce lawsuits, and so it comes as no surprise that plaintiffs’ lawyers have launched a securities lawsuit against MF Global, its corporate parent, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ March 10, 2008 press release can be found here. The plaintiffs’ complaint (here) focuses on the statements in the company’s Registration Statement and Prospectus, prepared in connection with the company’s July 19, 2007 IPO, particularly the sections headed “Disciplined Approach to Risk.” The complaint alleges that the statements in the Registration Statement and Prospectus about risk controls were false and misleading.
UPDATE: On March 12, 2008, plaintiffs’ attorneys’ announced (here) that they had filed a securities class action lawsuit against Societe General and certain of its directors and officers, on behalf of Soc Gen shareholders (both those who purchased their shares in the U.S. as well as those who purchased their shares overseas), alleging among other things that defendants had made mispreresentations and omissions, including allegations that defendants had misleadingly "touted SocGen’s conservative management, risk control, and expertise in risk analysis and structured finance." The plaintiffs specifically refer to the company’s "lack of sufficient controls " that permitted Kerviel’s unauthorized trading.
The complaint alleges that the defendants not only misrepresented the company’s risk controls, but “failed to disclose that in an effort to speed trades and to be ‘efficient’, MF had suspended or eliminated its own internal risk management technical and human controls and supervision, and failed to disclose that it eliminated credit and risk analysis and buying power limits and controls from its systems, effectively allowing any MF employee to place order without regard to the account’s satisfaction or margin requirements, collateral or ability to pay.”
Companies with problems arising from the activities of a single trader are not the only ones facing securities litigation allegations based on alleged breakdowns in controls. As the CFO.com article linked to above catalogues, many financial institutions’ recent massive write-downs may be tied to exposures arising from the breakdown or circumvention of controls. Allegations based on these control failures are a common feature of many of the subprime-related securities class action lawsuits.
These allegations have arisen in lawsuits against companies as diverse as Ambac Financial Group (which plaintiffs allege, among other things, lacked requisite internal controls to ensure that underwriting guidelines were followed); Accredited Home Lenders Holding Company (against which it is alleged, among other things, that management actively encourage circumvention of internal guidelines); and Countrywide Financial Corporation.
To be sure, many if not most of the subprime-related securities lawsuits also contain allegations of accounting and financial fraud, but underlying the financial disclosure allegations are claims based on breakdowns in controls. Shareholders who believed that prior gains were the product of a controlled risk environment may well object when they learn of losses arising from the circumvention of claimed risk controls.
The circumvention of controls may ultimately proved to be the unifying theme in subprime litigation, arising not just in claims involving public companies and their shareholders, but also in claims involving securitizers, mortgage originators, bond insurers, rating agencies, hedge funds, and a multitude of other marketplace participants. But as the MF Global case proves, the damages that can arise from control breakdowns are hardly limited to the subprime context alone. The MF Global case also shows how quickly damages can accrue – whether the breakdown involves a single trader or more systemic activity.
Evading Constraints: An American Heritage?: Those contemplating the origins of the conduct described above may want to consider an historical explanation. In Throes of Democracy (here), a new history of America during the years 1829 to 1877, by Walter A. McDougall, the Pulitzer-Prize winning historian from the University of Pennsylvania, Mr. McDougall writes that “Americans tolerate and even encourage corruption, so long as it appears creative in the sense of evading artificial constraints, hastening development and expanding opportunity.” He adds that “since the United States has been the most dynamic nation on earth…it is only to be expected that every age of American history is awash in old and new forms of corruption at every level of business and government.”
McDougal’s words may provide an explanation of sorts, but not a defense.
Now This: Others may be spellbound by the news involving Eliot Spitzer, but personally I am more consumed with the recent information regarding Dawn Wells. Wells, you may recall, played the part of Mary Ann in the TV show “Gilligan’s Island.” According to news reports (here – check out the picture), Wells is “serving six month’s unsupervised probation after allegedly being caught with marijuana in her car.”
Those of you who think this news provides additional information relevant to the perennial “Mary Ann or Ginger” debate should also be aware that at the time of her arrest, Wells was on her way home from a party for her 69th birthday.
The official Dawn Wells website may be found here.