Chapter Eight

What’s Next?

No look at rogue traders would be complete without some sort of attempt to explain what ties them all together. It’s easy enough to recount the stories themselves and, with any luck, discover the individual motivations that drove these traders to circumvent the law. But it has to be more than just that. There needs to be some sort of understanding, something to make it easier to prevent such occurrences from ever happening again.

Some say the answer lies with the values that we as a society place on making money. Could the root of the problem be the individuals themselves? In every case that we looked at, there was an intentional act of deceit by a trader. It’s the common thread that weaves its way throughout the stories. Whether the initial justification was to hide an error, preserve one’s status, make money, or save a job, the fact is that in every case, there was an intentional desire to deceive. Nick Leeson said in June 2013, “Immature people with status will do anything to protect it.” So then it’s possible that the whole rogue issue goes back to one’s mindset.

Blinded by what amounts to the personal desire to acquire more money—call it greed, for lack of a better term—the entire banking industry is indicted by the acts of a very few individuals. The idea is that banker’s greed is the driving force above all others is a little too simple, almost a cliché. The reality is that we live in a world that needs a banking industry, be it for savings, raising capital, processing financial transactions, investing, or financial planning. Those activities require financial institutions, plain and simple. There will always be employees at banks whose job it is to buy and sell investment products—that is, make money for the bank.

Anytime a rogue trader’s actions are made public there is a knee-jerk reaction. Calls for more governmental intervention in the form of new rules and regulations are the most common outcries. Occasionally, there is justification for it. The Glass-Steagall Act following the Great Depression was legislation that was truly needed. But all too often, the new laws don’t change as the industry changes, and rogue traders are going to be rogue traders, regardless of the laws prohibiting their actions. Case in point: Ever since the Drysdale collapse in 1982, financial services have become increasingly more and more regulated, but the new laws haven’t prevented illicit trading activities. Why?

To go even one step further, there is a negative correlation between the amount of regulation and rogue trading events. The more regulators have done to try to control trading activities, the more incidents that have surfaced—and the losses have grown larger. Almost all of these stories occurred at regulated financial institutions, and losses grew larger as the years went on. Ironically enough, only one story concerned the actions of a hedge fund trader. Counterintuitive as it might seem, fraudulent trading at unregulated hedge funds is far less common than at regulated banks. So the answer is more than the need for new laws.

Perhaps, then, the answer lies with the regulators themselves—the people who are charged with ensuring that the banks are operating within the parameters of the law. Top-flight minds often go to work for the banks themselves because, after all, that’s where the real money is. Given that the sharpest minds migrate there, it only makes sense that they can stay ahead of their counterparts at the regulatory agencies. In essence, smart people continue to develop complex instruments, and the regulators are left playing a losing game of catch-up. Regulators can keep making better mousetraps all they want, but the business schools will just keep on churning out smarter mice. Perhaps that’s part of the problem, but it still doesn’t explain why rogue trader events happen in the first place.

There are usually two parts to every rogue trading story—a trader with a willingness to exploit the system, and a manager or institution who fails to notice it. The next logical suggestion could be that better management is needed. In recent years, bank managers and the heads of trading groups have often been made up of career bank administrators. Promotions at banks are all too often based on politics and connections rather than experience and expertise. The trading manager is no longer the lifetime employee working his way up on the trading floor; instead, the job goes a person who is usually a lifelong management trainee being shuffled around the globe on different assignments. There is a clearly a stronger need for a better understanding of the risks a bank is undertaking. But as you might surmise, that solution, too, is only part of the problem. It still doesn’t fully explain why rogue trading events occur.

One point I have stressed throughout the book is that many rogue traders operated in new markets, pedaling exotic investment products that did not even exist even a few years before. And these aren’t run-of-the-mill stocks and bonds either. Remember, there are smart people creating assets involving wildly complicated math and permutations of matrices.

In the case of David Heuwetter, the repo market was a brand new financial tool just waiting to be exploited. Howard Rubin was operating in the newly created mortgage-backed securities market. Joe Jett exploited the Treasury STRIPS market and Kidder Peabody’s inability to account for the transactions properly. All of those markets were relatively new at the time. The list goes on. If the head of a trading group doesn’t really know what the traders are doing, how can that person be expected to adequately oversee it? The problem here is that it’s hard to prevent a bank from creating new financial products. Financial innovation provides lucrative new businesses, and everyone wants in on it.

While understanding new markets takes time, perhaps the best risk management systems can overcome those risks. However, it’s a proven fact that a bank can have the most state-of-the-art risk management system, one that covers 99.999 percent of all possible scenarios, but a single person who represents that .001 percent can exploit the system to his own gain. You had the best and brightest mathematical minds at SocGen developing the best risk management system in the world, but they were still outsmarted by a lowly former middle-office trader. Risk management is clearly not synonymous with fraud management.

In a global sense, there could be a problem tied to the culture of the financial industry. There is, truthfully, often little stigma attached to someone who takes monumental risks in order to generate profits and then fails in that attempt. In many cases, traders who have posted losses and have been publicly humiliated have gone on to even bigger salaries at new jobs; the logic is that their luck is bound to change, so best to get them now. In other words, buy low and sell high, the mantra of Wall Street.

Case in point: Howard Rubin landed a job at Bear Stearns soon after he was let go from Merrill Lynch. The difference here is that Howard Rubin was never formally charged with any wrongdoing, except maybe being a bad trader back in 1987. That fact flies in the face of the argument put forward by Joe Jett, who claimed that no Wall Street firm would hire a rogue trader. Of course, there are plenty of examples—including many of the people portrayed in this book—that didn’t have quite the same luck. In reality, anyone who went through the legal system or was convicted of fraud does not go back to a Wall Street trading job. Being labeled a risk or a loose cannon or even a rogue is not tantamount to perpetual unemployment, but being convicted of one is.

So again we return to the question of how to fix the problem of rogue traders. How do you counteract human nature—the inherent belief that a short-term benefit is worth the potential of a long-term loss? Of course, when the short-term benefits are large enough, they can easily cloud a person’s long-term view. The answer, unfortunately, is elusive at best. It’s safe to assume that companies will continue to enhance and refine their risk management policies, and that there will always be someone out there wily enough to circumvent them—especially in a new market or with a new product. Just when it appears there are sufficient rules and monitoring in place, new markets are created, or trading shifts to a new venue.

One solution du jour  is the concept of deferred compensation for traders. Essentially, the idea is to tie employees to the long-term performance of the bank by holding back their bonuses in the event that something goes wrong. It is, in a way, an attempt to bring back the business model of the partnerships that once dominated Wall Street. But there’s a major difference between the two models: In a partnership, the employee is a partial owner of the business, whereas with deferred compensation, the employee is just waiting to receive the money that he or she earned. If a trader is owed a million-dollar bonus but has to wait years to get it, there is a potential to lose the entire thing to activities beyond the trader’s control—like a loss in a faraway office in a completely unrelated product. So while deferring bonuses might seem like an easy fix, they’re not without inherent disadvantages. Compared to having an ownership stake in the business, it’s a system that is the same as the difference between chaining an employee to a post in the yard and letting the employee live in the house.

Way back when, Antoine Paille suggested giving his traders an equity stake in the business to the management of SocGen. His idea was roundly rebuffed and never implemented. The consequence was that Paille and many of his top people left the bank. The results of that failure speak for themselves.

If banks truly want to curtail rogue activities, then the suggestion put forth by Paille really has some merit. Back in the times of the Wall Street partnership, traders were tied to their ownership in the firm and their retirement package throughout the duration of their career. That situation changed dramatically as the firms became public entities, and traders benefited from an extreme upside and limited downside when they were taking risk.

Again, this differs dramatically from the idea of withholding compensation. It does, however, give the individual trader a similar carrot at the end of the stick, a goal to work towards that serves as a deterrent for everyone in a business to prevent fraudulent activities. But, as Paille discovered, that idea is not a popular one with the banks.

To my mind, then, we’ll continue to read about rogue traders in the future. It’s an unfortunate reality, but it’s a reality nevertheless. It’s entirely possible that there’s nothing that can be done to protect against rogue activities. The status quo is for more rules, regulations, and procedures to police traders at banks. There’s nothing imminent that might change that status quo. But rest assured, there is something the average investor—and, for that matter, the average trading manager—can do to protect against the fallout from such characters. Mind you, even the most hurricane-proof structure can be demolished by a powerful-enough storm, but any amount of protection is better than none. So while there is no way to fully insulate from the possibility of falling victim to a rogue trader, the better you defend yourself, the less likely it is to happen.

The best protection available to an investor who wants to steel himself against the calamitous destruction that can be wrought by rogue traders is education. And that’s why I have written this book. So long as we live in a world that requires the exchange of currency for goods and services, people will need money to survive, which means we’ll always be investing and trusting our money to Wall Street banks. Knowing the right warning signs can keep you safe. The next rogue trader might already be at work, perfecting his scheme. Your best defense is to learn from the mistakes made by others—many of whom deemed themselves too smart to fall for these sorts of things—and use that knowledge to shield yourself. As Benjamin Franklin so famously said, “An investment in knowledge pays the best interest.”