Rogue traders and stated-income borrowers

The financial scandal du jour is a $2 billion dollar loss at UBS blamed on a “rogue trader”. You’d think the whole “rogue trader” problem would have been solved by giant, sophisticated investment banks. After all, it was way back in 1995 that Nick Leeson brought down a 233 year-old global institution. Since then we’ve had John Rusnak at my hometown bank, Jérôme Kerviel at Société Générale, and others.

Kid Dynamite, a former trader himself, notes that “losing $2B without anyone knowing about it is much harder than you think“. To generate a $2 billion dollar loss in a short period, a trading position has to be gargantuan. Some dude on a trading desk can’t just put on that kind of trade. He’d have to get buy-in from superiors and risk managers, which probably means making up justifications or falsifying hedged positions. Derivatives trades require collateral posting, and securities trades settle in cash. You’d think the bean counters would take note when large sums come and go through the accounts. Perhaps these “rogue traders” are supergeniuses who reroute the accounting ledgers through the lavatory plumbing at the exact critical moment. Otherwise you’d think that detecting unauthorized positions of $10B-ish would be the sort of thing that masters of the universe would be capable of doing.

This is the Green Room has a delightfully wry take on the affair:

The revelation that yet another rogue trader has been pulling the levers at a major bank…makes me wonder about all the rogue traders we’re not hearing about — the ones who aren’t big, stupid or aggressive enough to get caught… Perhaps banks should start reporting “income from rogue trading” in their financial statements. It would seem naive to presume that it isn’t contributing to the bottom line.

It is a commonplace now to talk about troubled banks’ incentives to “gamble for redemption”. It has also become cliché to talk about how traders’ asymmetrical incentives encourage risk taking: If we take a big risk and make a lot of money, we get huge bonuses. If it doesn’t work out, worst case scenario is we lose our jobs. Of course, regulators discourage gambling for redemption, at least in theory. And all else equal, nobody wants to lose their job, not to mention the deferred compensation that is supposed to discourage this sort of thing. Still, there is a sense in which the bank “wants” big risks to be taken, as do a variety of employees with exposure to the upside in their bonuses. But it would be better if the risks were taken in some manner that, if things go south, no one could be blamed. Well, almost no one.

I am reminded of a wonderful post by Tanta at Calculated Risk, on stated-income loans:

I have said before that stated income is a way of letting borrowers be underwriters, instead of making lenders be underwriters… What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.

We use the term “bagholder” all the time, and it seems to me we’ve forgotten where that metaphor comes from. It didn’t used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scarpered. I’m really amazed by all these self-employed folks who keep popping up in our comments to defend stated income lending. It is a way for you to get a loan on terms that mean you potentially face prosecution if something goes wrong. Your enthusiasm for taking this risk is making a lot of marginal lenders happy, because you’re helping them hide the true risk in their loan portfolios from auditors, examiners, and counterparties. You aren’t getting those stated income loans because lenders like to do business with entrepreneurs, “the backbone of America.” You’re not getting an “exception” from a lender who puts it in writing and takes the responsibility for its own decision. You’re getting stated income loans because you’re willing to be the bagholder.

Maybe “rogue traders” aren’t devious supergeniuses after all. Maybe they’re just the stated-income borrowers of high finance, people willing to indemnify their quietly enthusiastic “victims” by being the one to tell a lie.


14 Responses to “Rogue traders and stated-income borrowers”

  1. […] Rogue traders and stated-income borrowers Steve Waldman […]

  2. […] Rogue traders and stated-income borrowers Steve Waldman […]

  3. Doc at the Radar Station writes:

    25 Million Pounds
    Interesting documentary about the Baring’s scandal…

  4. JKH writes:
  5. Rogue trader? Bah humbug! This is total nonsense. Ex post the bank says he is a “rogue trader”. Why? He lost money.

  6. GA writes:

    It should be fairly obvious that banks are being deceitful in one easy, easy swoop: no big bank has ever announced a significant windfall profit from unauthorized trading. And it cannot be the case that the only unauthorized trades that have ever been found have lost money.

    Until such time as a large bank identifies that they made a huge profit from an unauthorized trade, we can assume that what they are all doing is hiding those unauthorized trades that are money good in their ‘usual trading income.’

    And as you note, smaller frauds/unauthorized losses are not identified or published.

    If you add together all of these, it is likely the case that a far more substantial amount of the income/risk from trading is due to essentially having a system that is dysfunctional, at virtually all banks.

    And one would think that the capital requirements on this would be much more onerous.

  7. Indy writes:

    Can’t resist the pun – someone has to set up a “Rogue’s Gallery” post, with biographies, etc.

    But of course, the real problem here is only that we’ve neglected to appropriately price this into our models, and hedge the risk away, ultimately, to the taxpayer. Next thing you know someone going to create some newfangled synthetic derivative financial instrument which purports to specifically insure against this kind of event. Call it a “Rogue Loss Swap”. Insurable Equity! And if everybody is writing and selling RLS’s against everybody else, it should all work out great.

  8. […] interesting thoughts on the UBS rogue trader […]

  9. Joe Smith writes:

    The trading has to be done through a computer and appropriate computer programming would lock out rogue trades. More likely this poor bastard pulled short straw when it came time to pick a fall guy.

    Stated income borrowers are probably usually either lying about their income to get the loan or evading taxes.

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  13. Tom Lindmark writes:

    I recall this post by Tanta and thought at the time I read it that she had nailed it, but it sort of turned out differently didn’t it. Those stated income borrowers never were called to account for their actions, meanwhile the banks are slowly getting backed into a corner by those who invested in their loans. It took a while but at least partial justice might be served.

    So, might the same fate befall those that you postulate may be profiting from the actions of rogue traders?

  14. […] including John Gapper of the Financial Times (A rogue trader at UBS or a rogue bank?) and Steve Randy Waldman of Interfluidity (Rogue traders and stated-income borrowers) have suggested that, in its quest […]