English: Expres Bank - Société générale retail...

Former Société Générale rogue trader Jerome Kerviel owes the bank $6.3 billion. I did mention him in my last posts SocGen Rogue Trader Jerome Kerviel and Rogue Trader Jerome Kerviel is Back .

Jerome Kerviel is learning one of life’s harsher lessons: It stinks to be $6.3 billion in debt. That’s how much his fraudulent trades in 2007 and 2008 cost French bank Société Générale, and how much he has been ordered to pay in restitution — after he gets out of jail in three years. A judge recently upheld these terms on appeal.

Stay risky, my friends?

But how exactly do you carry out €50 billion ($73 billion at the time) of unauthorized trades? With lots of computer hacking and not a lot of vacation. Kerviel was an arbitrage trader at Société Générale who wanted to take out the “arbitrage” part. In plain English, arbitrage just means taking advantage of discrepancies when things should have the same price, but don’t. The idea is to buy the cheaper one, sell the more expensive one, and then wait for them to converge. The beauty is it doesn’t matter whether markets go up or down — you’re both long and short — just that the prices actually converge.

This is what Kerviel was supposed to do with European stock futures. He only did half of it. In other words, he took, say, a long position and then pretended to offset it with a fictitious short position. That’s where the computer hacking came in. But how did he end up betting such mind-boggling sums? Well, arbitrageurs are usually exploiting such small price discrepancies that the only way to make decent money at it is to bet lots and lots of money. And Kerviel certainly did that. Société Générale didn’t notice because it only monitored the net, and not the gross, value of these paired trades — which again, were not really paired. So the bank took Kerviel’s actual bets and subtracted his fake bets. Voilà, €50 billion worth of trades disappeared. Of course, it’s impossible to maintain a continuous fraud like this if you’re not at work. That’s where vacation, or the lack thereof, comes in. That’s another banking no-no, precisely to prevent this kind of chicanery. By the time Société Générale uncovered the fraud, Kerviel had built up huge one-way bets and huge one-way losses.

Kerviel certainly isn’t the first rogue trader, nor will he be the last. But is there anything we can do about these massive failures of bank risk management? And just what happens when you owe billions and billions of dollars.