“We accuse the Société Générale of a violation of the federal laws” (1/2)

While the Kerviel trial is about to start in Paris a new case is opening in New York for the Société Générale. The class action brought in January having been deemed acceptable, the bank has to transmit its answers to the charges before April the 15th. The plaintiffs consider that the Société Générale has concealed the impact of the subprime mortgage crisis on its financial results (1/2) and turned a blind eye on Jérôme Kerviel’s actions if not protected him (2/2). Translation of french by VCK. Read it in french.

Its title may not be very catchy but it is a valuable document for someone who wishes to understand the crisis of the Société Générale. The document, entitled “Second amended and consolidated complaint for violation of the Federal Securities Laws”, counts 214 pages of accusations. Jérôme Kerviel, the subprime mortgage crisis, these unsafe mortgage loans, tactless managers, low blows, anonymous witnesses, computer operations done in haste, kings of derivatives ousted one after the other… These are some of the things that can be found in the lawsuit filed by the American lawyers representing the Vermont Pension Investment Committee, the Boilermaker-Blacksmith National Pension Fund, the United Food and Commercial Workers Local 880 in Cleveland (Ohio).

The File N°1:08-cv-02495-RMB made available to the public by the United States District Court for the Southern District of New York contains  a great deal of figures but also the main episodes of a Wall Street III script which plot unfolds between New York and Paris from 1^st August 2005 to 25^th January 2008.

Before discovering the document in depth a word on the motivation of the American solicitors specialised in class actions, these collective lawsuits that enable several victims to bring together their complaints and to join forces – in other terms “money”. It is somewhat curious to observe bankers mouthing reproaches as they seem sincerely offended by the method. A first complaint, filed in Spring 2008, was dismissed and was only covered by a few quick articles in Les Echos, Le Figaro or The New York Times, that remained unnoticed. Only one existential blogger on “Je-blogue-donc-je-suis” (I blog therefore I am) took the trouble to read the 184 pages of the first complaint.

The attack still lacks elegance but this time the Générale will have to answer it and will not get out of it, even if after a four or five year long procedure they are likely to face a condemnation similar to the one issued to Vivendi last January. For the time being, the bank has refused to comment and is actively working on an reply. The judge Richard M. Berman has indeed given to the bank and the other defendants (among which Daniel Bouton, former chairman of the bank) until April the 15^th to answer in a text written jointly that cannot exceed 40 pages.

Let’s lift the curtain on the probable strategy of the defence. It should be based on an established fact: they followed the accounting standards enforced in France between 2007 and 2008. Our financial data may appear incorrect to Wall Street, they will say, but is in fact accurate, in spirit, sincere and true to the reality observed in La Défense (the bank headquarters), the Paris stock exchange, the Financial Markets Authority or the Banque de France. So it is all a matter of point of view.

What can a pensioner from Vermont and his greedy solicitor blame the Société Générale for? Almost everything. The first complaint appears on page 1, paragraph 3. The plaintiffs leave little time for introductions so quickly do they start attacking: during the period covered by the complaint, from 1^st August 2005 to 25^th January 2008 five Société Générale administrators sold 225 million of euros worth of their Société Générale shares using insider information and concealing the real financial situation of the bank. This is America, so the reproach is not on the profit made but on “the concealment of the extent and nature of the Company’s exposure to the U.S. subprime mortgage market”. Two more serious accusations follow. Firstly, the bank tried to conceal the consequences of the mortgage subprime crisis, as one hides dust under he couch. Secondly, the company turned a blind eye on Jérôme Kerviel’s actions. Read about it tomorrow.

The whole point for the American shareholders is to demonstrate that their trust has been broken until January 2008. On this date, Daniel Bouton uncovered this incredible story: a trader, named Jérôme Kerviel cost to the bank 5 billion euros in a fraud (read the upcoming second part of our enquiry). SocGen chief executive also revealed losses of €2bn linked to the subprime mortgage market. This is when the American shareholders begin to lose their temper.

The Subprime Mortgage Crisis day by day:

8 February 2007. HSBC, a top 4 world bank, a major reference for international markets, reveals its provisions are set to raise from $8bn to $10bn due to the degradation of the US housing market; in one of the first signs of the subprime  mortgage crisis, these variable-rate mortgages.

2 April 2007. New Century, a leading subprime lender, files for bankruptcy (under Chapter 11) following a rise in  people defaulting on their loans.

8 August 2007. BNP Paribas suspends three of its investment funds with subprime investments. The European Central Bank (ECB) injects 95bn euros into the eurozone banking market to prevent a credit crunch based paralysis.

14 September 2007. The BBC reveals that the Bank of England has given emergency support to the Northern Bank. A number of worried customers withdraw their savings.

7^th September 2007. Daniel Bouton tries to restore confidence to the public. In an interview to Le Figaro he states that the “credit crunch is under control” and that the bank has only “limited exposure to US mortgage and LBO financing.”

10^th September 2007, Frédéric Oudéa, then Financial Director of the group, pays a visit to New York and attempts to be more precise in front of financial analysts during a Conference summoned by Lehman Brothers. In a prudent statement, the man who was to become the big boss of the SocGen, states that the bank has only “limited exposure to US mortgage and LBO financing.” Less prudently, he further says: “In a scenario of 150 billion USD cumulative losses on subprime mortgage loans for the whole industry, SG CIB estimated loss under 100 billion USD (for a total cumulative industry loss of 200 billion USD, SG CIB estimated loss under 200 bn USD).”

The 19^th September Daniel Bouton tries again to show confidence in an interview to Les Echos: “The subprime crisis in itself will cost from 150 to 250 million USD  to the world financial market. It is manageable.(…) However, for the time being, the risk of a contagion to the rest of the economy is limited.” After all, 200 billion dollars or 175 billion euros is nothing to worry about. Actually, what upsets New York is the discrepancy between what was announced as 175 million euros in December and became 2 billion euros in January (of which 1.1 billion directly caused by the American real estate crisis).

24 January 2008. The Société Générale reveals the Kerviel incident and announces that it provisions €1.2bn to cover losses in the American real estate.

15 February 2008. The Swiss bank UBS announces a loss of 12.4 million Swiss Francs on the fourth quarter of 2007.  The bank admits having 44 billion USD depreciating assets due to the subprime crisis.

The Société Générale shareholders see the value of the shares drop: 140 euros in May 2007, 100 euros in September, 85 euros when the big boss says that the situation is “manageable”, 65 euros when the news breaks, on the 24^th January 2008 and 47 euros according to the latest news (Nyse Euronext FR0001130809GLE). In France the fall of the supposedly loaded shareholders causes some heavy sneering. Meanwhile in Cleveland (Ohio), supermarket workers unionized to UFCW 880 are being told about their pension.

A system gone crazy

The accusation is based among others on half a dozen anonymous witnesses, the confidential witnesses (CW) who, employed by the Société Générale at the time of the events, describe a “system gone crazy”. Numbered from 1 to 6, the CW are quite easy to identify from the position they occupy in the hierarchy and their location, but, to know their name one will have to wait for the proceedings to go further and for the Générale to show what it has in store within the three week consultation. For the time being, they are posturing without showing it in full light. At the end of March / beginning of April 2007, witness CW1 says the bank’s American subsidiary is facing a liquidity shortage in the United States.

As such, it does not seem like anything to worry about, but we must remember that Lehman Brothers’ collapse was caused by a problem of liquidity. Witness CW2 recalls that at the time two managers of the Société Générale in New York asked for a quick update of the parameters of the Calypso technology, the software that rates CDOs (Collateralized Debt Obligations) which were linked to the American real estate crisis. At the time, one could not even say that prices were collapsing. Indeed, there are no more market, no more exchange. Specialists that are part mathematicians, part traders, did work 24 hours a day to find a balance, however in vain as the Calypso had stopped responding. Products that were rated 100 in August 2006, were sold for 60 in May 2007, 40 in September and 10 in December. How can one value something that has not any worth at the said moment? This is precisely the point to which CDO’s became a difficult matter.

American regulations allow banks to cease using market prices when there is no market. “Mark to market” is then replaced by “mark to model” and Calypso or other mathematical models are used to know how much a product is worth. The bank has to be trustworthy and manage a very difficult operation. If the value of financial products impossible to get rid of goes up, then all is well, if it goes down, the loss will have to be publicised someday.

Société Générale was in an excellent position to appreciate the impact of the so called subprime mortgage crisis. It had bought TCW, a Californian Company specialised in asset management, and was being helped by an outstanding specialist of the American real estate market, Jeffrey E. Gundlach. In June 2007, he bluntly announced in USA TODAY “In the world of subprime, it’s a major, major debacle” But nobody paid attention. At the time, Calypso is being toyed to make it give good news. Confidence will come back, equations will prove to be correct. This is apparently the message that the bank managers want to convey. Trying to make a risk model applying to the financial market is not absurd but sometimes one has to admit that the boat is too heavy and just about to sink. We are reminded of the overly confident Titanic’s Captain who kept rushing toward the icebergs of the North Atlantic.

“A crisis of this scale is unpredictable. In 1998, there were worries about South Korea, with national bonds being traded at 10% of their value. The markets are sometimes stirred by uncontrollable emotional reactions”, pleads an ex employee of SocGen.

But let’s get back to the calculations of the bank. They can be found in the maze that is the bank’s website, under the heading “Investors”. In December 2007, they announced a figure of 175 million, then two months later, 2 billion  to cover the whole crisis. Two years later risk was estimated to 35.5 billion euros. In a spreadsheet nicely entitled “Extinct assets, synthesis of exposures” SocGen produces a list of assets that cannot be sold on page 62. There is a full range of products to be handled with care that has been put to Société Générale: RMBS (Residential Mortgage-Backed Assets), CDOs (Collateralised Debt Obligations) and “exotic credit derivatives”. In contrast, “Those are not losses” affirms a Société Générale spoke person, annoyed when shown the monetary sum of products which do not appear on the document. We therefore find that one returns to the idea that a risky valuation is done in the moment, without considered calculation. They cannot be said to be ‘losses’, if valuated at this precise moment, but rather only risks. Who knows? Tomorrow these products might find a seller. Or not. Instable products do not necessarily explode, they just might do.

18 March 2008. The press reveals that the US Department of the Treasury has given guarantees to J.P. Morgan to enable the rescue of Bear Stearns, Wall Street’s fifth-larger investment bank. Its collapse would have sent shock waves throughout the financial system, it was feared.

13 July 2008. The Treasury Secretary, Henry Paulson, says that Fannie Mae and Freddie Mac will play a central role in the US housing finance system. The two (government sponsored) enterprises which guarantee more than 5,000 billion USD in mortgage loans are no longer able to substitute to defaulting borrowers.

The 35 billion figure appeared at the beginning of January in a short article by La Tribune and no one knew exactly what it stood for; now however we do, in addition how to possibly best react. All the toxic assets are transferred to an empty shell, Inter Europe Conseil, which will have to manage those illiquid assets. To put it clearly, they will be buried like radioactive waste; they will be waiting for Godot. Obviously no one dares say how much this will cost to the bank. To be precise, and accurate, 10 billion of these exotic products have already gone through profits and losses. The amount of the risk taken is of 45 billion euros. But let us make some historical remark: the state-owned company, Consortium De Réalisation (CDR) attempted to save the Crédit Lyonnais from a disaster that had 100 billion francs worth of toxic assets to manage. This time however it is thrice as much. In addition, there is an important difference between CDR and Inter Europe Conseil which is that the first was state-owned whereas the latter is not. But French taxpayers will not be completely spared since by regrouping its toxic assets in France the bank will be able to have some tax reduction by doing “financial optimization”. This should cost from 1.2 to 3 billion to the French taxpayers. But we shall see later when it is time to cash up. For the Société Générale it is still too early.

15 September 2008. Investment bank Lehman Brothers (28.000 employees) goes bankrupt. On the same day Merril Lynch is bought by Bank of America.

7 November 2008. The New York Federal Reserve nationalises AIG (60 million customers). The Société Générale which refused to negotiate with AIG’s obligations received 10 billions USD from the corporation and 7 billion from the State.

But for now, one last remark on how to make accounts more “acceptable”. The bank is not always as serious as its square logo may suggest. A proof of that is the losses of the Société Générale Asset Managements (SGAM) highly involved in the American adventure in the years 2007 and 2008. According to the balance-sheet, (p6) submitted to the Nanterre commercial court, the losses for 2008 are in the sum of 895.860.940€. Let’s say 896 billions euros. In the 2009 Reference document of the group (balance-sheet for the year 2008) the figure has spectacularly shrunk, losses are only of 43 billion euros. How do we get from one figure to the other? A calculator does the trick. The SGAM judges that the devaluation of TCW, a Californian subsidiary specialised in assets management in particular in real estate, has appear. To the 43 million losses one has to add up 513 million euros.

Same operation with another subsidiary, the SGAM bank and for 321 million euros. But when closing its books, when making the big addition of its own results, Société Générale does not have to take into accounts its subsidiaries credits. This is how the 834 million worth of certain losses disappear perfectly legally.

Fiddlers will say that we are still short of 19 or 20 million but it does not really matter. We had to insist over two long weeks to receive confirmation of our calculation. In the last reference document the figures for SGAM and its annual results have disappeared altogether behind the mention “undisclosed”. A few days before the 31^st December Société Générale gave up and merged 75% of the SAGM to the Crédit Agricole to create Amundi.

PhDx

Ps: One can found two dynamic timelines of the subprime crisis, the first on the BBC website and the second on Dipity.com. The New York Federal Reserve has produced an accurate timeline of the financial crisis (PDF). Check also “Financial Crisis of 2007-2010” on Wikipedia.