UBS rogue trader: why do they only seem to come with losses and not profits?

Friday, Sep 16 2011 by
5
UBS rogue trader why do they only seem to come with losses and not profits

The discovery by UBS that a rogue trader has run up $2 billion of losses, has raised not just a question over the Swiss bank's future but also as to how such an event could happen again? UBS losses, the London Evening Standard predicts could "prove to be the catalyst for the Swiss regulator to close down the loss-making, gaffe-prone investment bank". The bank, it notes, totted up $60 billion of losses during the sub-prime crisis in 2008, which in turn angered the Swiss public and triggered an identity crisis of existential proportions. A man has been arrested on suspicion of fraud, and is currently being questioned by police. UBS's chief executive said the loss does not affect the fundamental strength of the bank even though it will lead the bank to report a third quarter loss in 2011.

But that probably won't be much comfort to investors: since 2007 UBS has changed its chief executive three times as well as shutting down its proprietary trading arm. The level of anger towards UBS in Switzerland was on a par with the hatred felt towards UK bankers and their outsized bonuses. But it was worse - it was tinged with the humiliation of one of the most respected, discreet banking systems in the world being brought into disrepute. 

In the Evening Standard writer Nick Goodway asks how it could happen again? The future of the investment banking giant UBS in London hung in the balance today after it revealed that a single rogue trader had run up losses of $2 billion. UBS warned that this was likely to push it into the red in the third quarter and comes at time when the Swiss bank is axing thousands of jobs in a bid to slash costs. It currently employs 6800 staff in London.

The bank called the City of London Police to its head office beside Liverpool Street station in the early hours of this morning. A 31-year-old man was arrested on suspicion of fraud by abuse of position. He was being held in police custody. The UBS announcement came as complete shock even to most of its own employees who first saw it flash up on their trading screens. A loss of $2 billion would make this the single largest incidence of rogue trading in London. Jérôme Kerviel lost €4.9 billion taking huge bets on European stock markets at Société Générale's Paris headquarters in 2008.

UBS top management is now likely to come under huge pressure from both the London and Swiss authorities. Some people have even suggested that the Swiss National Bank could order UBS to close its investment banking arm rather than put its massive domestic banking business at any further risk.

Analysts today said UBS could survive the scale of the losses but that its reputation had been left in tatters. Fiona Swaffield, an analyst at RBC, said the bank had been seen as having recovered from the credit crisis and to have improved its risk management but added: "This brings that very much into question."

Kerviel's detection and arrest eventually led to the departure of SocGen's chief executive, Daniel Bouton, the bank's head of risk and a raft of senior managers in its investment banking division within 12 months. UBS chief executive Oswald Grübel sent an apologetic email to all staff today. Until today he had been seen as a strong boss of the bank, having  started to rehabilitate its after it lost $50 billion during the 2008 financial crisis. He ordered 3,500 global job cuts last month.

His future is now uncertain, as too is that of Carsten Kengeter, the head of investment banking. Analysts had been expecting UBS to make a third quarter profit of Swfr1.3 billion which could all be wiped out by the rogue trader's losses.

A former director of risk at UBS said: "I'm staggered by this. When I was at UBS, it was extraordinarily difficult for a trader to trade non-vanilla transactions. Two things shock me: one, the size, and two, that nobody else knew. When the Barings rogue trade happened, there were rumours in the market that things weren't quite right. This time, there's been silence. It seems strange that someone could rack up a deal so large it creates a $2 billion loss. There's always a counterparty, someone must have seen and known about it outside the bank."

Chief's email bids to ease fears of his staff

In a desperate attempt to reassure his thousands of staff in London and around the world, UBS chief executive Oswald Grübel sent an email to all staff this morning.

It read: "We understand that you have already had to contend with unfavourable, volatile markets for some time now. While the news is distressing, it will not change the fundamental strength of our firm. We urge you to stay focused on your clients, who are counting on you to guide them through these uncertain times.

"We want to reassure you that we, together with the rest of the management, are working closely with the Investment Bank's management and risk and controlling to get to the bottom of the matter as quickly as possible, and will spare no effort to establish exactly what has happened. We will keep you updated on the progress of our investigation."

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But employees were unimpressed. recruitment consultants reported a rush of inquiries from traders seeking an exit.

Early feedback suggests UBS staff in London only found about the unauthorised trade when the 'red sticker' went up on Bloomberg. The size of the loss suggests that UBS either has a Kerviel on its hands or a leveraged FX trade has blown up.

Mindful Money blogger Shuan Richards said

"Here is the headline from Reuters:

'UBS says a trader of investment bank has casued loss estimated at $2 bln'

This gave me two initial thoughts. The first was that rogue trades only seem to come with losses and not profits! Odd that is it not?In case you had any doubt rogue profits do happen followed by a rush of stamping feet by those anxious to take the credit! The relationship could not be more asymmetric. Also it confirms my view on bank stresses as these things tend to happen at such times or to be more specific we tend to be told about them in these times as otherwise they would be hidden.

What was it?

Now I rush to say I do not know in spite of it being a former employee of UBS. However if we look at the size and timing of this then it looks possible that UBS was long the Swiss Franc when the Swiss National Bank devalued and established a currency floor at Euro 1.20. Whilst you mull over the irony of the SNB hurting UBS (The Swiss taxpayer who has already bailed out UBS once might have other words to describe this…..)  let me give you a few more thoughts.

In my experience a large loss is usually accompanied by "somebody clever" coming up with a fix and in my experience this invariably makes the loss worse. This would explain why there has been a delay between the devaluation and this loss being announced now. Of course no-one will officially admit to this. Also under pressure individuals tend to hide such things as best they can even what you would consider to be "nice upstanding individuals", before the event anyway. I have worked with someone who under pressure put his loss-making deals in his bottom draw and kept them quiet. Of course he was soon found out and for the bank there is the issue of what to do next which in general is to keep it quiet if they can. If there is a theme in this it is that the pressure that markets can put on an individual's personality can be extreme and sadly some do break under it. This is rarely reported for obvious reasons but there you are and I can assure you that if you are a witness to it the questions it raises are difficult to fully answer.

As I have touched on a grim subject I am in need of a good laugh and fortunately someone in a comment on the FT website has provided me ( and hopefully you) with it. This is from the UBS Risk Management brochure."

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18 Comments on this Article show/hide all

Fangorn 16th Sep '11 1 of 18
2

Can't help but notice there's a common theme with all these rogue trader losses.

And that's they all seem to be done by "young" traders.

Kweku Adoboli 31
Jerome Kerviel 31 in 2008 at time of Socgen fiasco
Nick leeson 25 when the problems started, 28 when he busted Barings.

So more prone to raking excessive risk in search of bigger bonuses.

Solution would seem obvious in my view - don't put such young people in charge of massive trading books. Go for more experienced elder stateman than testerone fuelled youngsters.

What is it about youth and risk taking that attracts all these investment banks to put such young people in charge of large proprietary trading books. And how is it that risk management controls/back office systems fail to spot such excessive risk taking?

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ExTownie 16th Sep '11 2 of 18
9

In reply to Fangorn, post #1

Fangorm,

I'm not sure that age is the key problem here. A lot of it comes down to three issues for me:

1. Valuation - Systems are not perfect.  Not every trade will be correctly valued by the bank's system.  To a trader who spends his life looking for arbitrage opportunities, he is also able to arbitrage the bank's system against the market.  There is a temptation for a trader who is under pressure to perform, to create some profit, particularly on a bad day.  Unfortunately once you have started down this path, it can be a slippery slope.  Many traders use this valuation anomaly to understate profits, or create a squirrel as it's known, so this can be raided on a bad day to make profits appear more smooth than they really are and give the impression of less risk taking. Kerviel and Leeson both came up through the back office, a practice that needs to be stopped since it allows traders to know the gaps in the system.

2. Staff Quality - A good trader earns an order of magnitude above that of a good risk manager.  Yet quite a few of the same technical skills are required for both jobs.  It isn't a surprise that the more talented individuals end up behind the trading desk.  It is very difficult for a risk manager to really get to grips with every aspect of a trading book, since he is dealing with a trader who spends his waking hours focussing on the intricacies of that market.  The risk manager's questions can often be tackled by the trader in a plausible way as the risk manager simply lacks the real market experience to spot the problem in the deliberately detailed explanation.

3. Hierarchy -  An apparently successful trader is a hugely valuable person and considered to be of much greater value to a bank than a mere risk manager.  The management may well not tolerate a risk manager giving the star trader a hard time, so it would be a career-limiting move.  There is often a feeling within a bank that a star trader is untouchable - no one dares question their authority since they don't want to annoy and potentially lose them.

Often the only person capable of overcoming these three issues is the head of the trading desk, who is a trader himself.  If he keeps a sufficiently close eye on his traders, his detailed market knowledge should allow him to spot the problem.  If the head trader is the one causing the problem, then that's a whole lot more complicated.

 

ET

 

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Fangorn 16th Sep '11 3 of 18
2

Interesting comments ExTownie.

On the valuation concerns I concur systems are not perfect - and these arent helped by the vast array of exotic structured projects that are traded these days, the valuations of which are often very subjective(particularly the illiquid or very exotic).

As to staff quality,surely having more experienced and, one hopes, wiser, individuals trading the book ( less inclined to punt the bank on a potentially profitable trade) is preferable to the over exuberance of young traders in their late 20's,early 30's. A bit of caution and reflection, weighing up the pros an cons, with suitable reference to the possible damage to the bank if it goes wrong, surely is in order.

How many of us, engage in the latter these days,but, when we were of similar youthful age, were similarly "gung ho" blinded by the potential rewards on offer for excessive risk taking?


In relation to your
"Often the only person capable of overcoming these three issues is the head of the trading desk, who is a trader himself. If he keeps a sufficiently close eye on his traders, his detailed market knowledge should allow him to spot the problem. If the head trader is the one causing the problem, then that's a whole lot more complicated."

Which would lead me to suggest that a 31 year old shouldn't be the head trader on "any" desk where excessive leverage is being undertaken. If there was a senior experienced head trader monitoring what Adoboli was doing why was he unable to spot the problem? (no experience in that particular product?) Surely there much be daily communication on how "positions" are doing?

All very worrying however as it seems lessons are not being learned, excessive losses from unauthorised risk taking continue...and each time we hear "lessons have been learned"

Having worked in the City, predominantly overseas, I have to say it's an utter shambles what has gone on at UBS.

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ExTownie 16th Sep '11 4 of 18
4

Fangorm,

I agree completely about exotics - banks seem to feel obliged to quote on ever weirder structures. There appears to be a macho culture driving that business- lots of banks that want to play with the big boys probably lose money over the longer term. I would guess that only a handful do it successfully, at the expense of the rest.

Rogue traders are far more common than banks will admit, since many are quietly made redundant and allowed to continue their careers elsewhere in the City. This avoids the need to bring in the FSA and admit to risk management failures. The ones we hear about are the losses that are too big to absorb. In my City career I have seen four or five that didn't make the headlines at banks I worked for, so there are likely to have been hundreds in the wider market.

I really don't think age is a major factor though - one of the ones I knew was in his forties. Another potential one that was removed before we got the chance to find out for sure was about fifty. The culture at investment banks makes life very hard for underperformers, so the temptation to hide losses when all around appear to be making money must be great. I was a desk head from my late twenties and I took the job very seriously. I had one rogue trader in my team, but spotted him early enough to prevent significant damage. It was still in seven figures though. The wake up call came on what I knew should have been a bad day for him in an otherwise quiet market. Looking at the figures, I saw he was almost flat on the day which made no sense to me. I spent the evening trying to understand where the loss had gone, suspending him the next morning so I could spend three days going through every trade.

I do think there is a good case for senior bank management to be older and more experienced though. To understand the big picture they should have seen enough economic cycles to make sense of the current situation.

ET



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Fangorn 16th Sep '11 5 of 18
2

I suspect it would help if many of the senior bank management had actual experience in the products their institution was trading as well - was that not the reason for Barings fall.None of them had a clue about the Nikkei derivatives Leeson was punting. One suspects similar here.

Your own personal experience illustrates that any manager who is overseeing has to have the relevant product experience to be able to spot the irregularities.

I accept that rogue trading is not the sole preserve of youngsters, but they do seem to hit the headlines far more often than their elder counterparts. But agree, the pressure not to underperform is immense...don't miss the city at all.

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kenobi 16th Sep '11 6 of 18
1

why do they always make losses ?

why would they tell us about ones that make a profit ?

infact as mentioned by someone else they only tell us when it's an amount too big to hide.

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ExTownie 17th Sep '11 7 of 18

I see Peston has now reported this UBS trader was ex back office.....

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emptyend 17th Sep '11 8 of 18
2

In reply to ExTownie, post #2

Precisely, ET.

The FT today points out that all the brains gravitate towards positions where they can get paid most...so traders are paid more than compliance and back-office ....and more that the regulators too!

An apparently successful trader is a hugely valuable person and considered to be of much greater value to a bank than a mere risk manager.  The management may well not tolerate a risk manager giving the star trader a hard time, so it would be a career-limiting move.  There is often a feeling within a bank that a star trader is untouchable - no one dares question their authority since they don't want to annoy and potentially lose them.

This is 100% spot-on. And I would also add that the tiering of bonus systems subverts the whole process of controls. I once briefly worked for Kidder Peabody, arriving just after Joe Jett's activities had been discovered - and it is completely clear that Jett's apparent profits went largely unquestioned because he was protected by all those in the chain of command above him...because their own bonuses dependied on his profits being real (in fact it was an accounting game, where the accounting systems dealt wrongly with the accrual of interest).

ee

 

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emptyend 17th Sep '11 9 of 18

In reply to Fangorn, post #5

I suspect it would help if many of the senior bank management had actual experience in the products their institution was trading as well - was that not the reason for Barings fall.None of them had a clue about the Nikkei derivatives Leeson was punting. One suspects similar here.

The problem in the Leeson case was that there was no trading oversight at all of his trading activities - he was virtually "his own man" in Singapore! There WERE people in London who would probably have spotted the problem - but he didn't report to them (until only 5 weeks before the earthquake arrived). Instead he reported locally - and simply didn't get enough oversight!

As to the point about lack of "actual experience" amongst senior managers, I have repeatedly pointed that out over the last decade.....but it shouldn't be a surprise and it is generally impossible to remedy - because most of the problem areas are heavily mathematical and demand skillsets in derivatives mathematics that senior managers of large universal banks have generally not possessed! It is in the nature of things that the new areas of activity are invented by the young and thrusting - the role of the older people is basically to tell them not to do stuff that they cannot be explained clearly to those outside their group.

That is why the demographics are as you point out.

ee

ps......I knew Leeson's London boss very well at that time.

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kirkie001 19th Sep '11 10 of 18
4

Tuppence-h'appeny worth, over a morning coffee:

A common link in some of the most recent large incedents (as has been mentioned) is knowledge of the back-office systems by those working in the front office. At UBS, I've seen it said that their 2008-9 'cost cutting' involved letting a lot of front-offfice staff go, and promoting others (inc trade support) into front-office.

There needs to be an institutional-wide ban preventing middle and back-office staff from moving into front office at the same organisation.

The other point is on how this was hidden - apparently using forward-settled 'trades' to avoid cash showing up. The fundamentals here come down to the "C's" (as I was taught) - counterparty, collateral, cash.

- Counterparty confirmations shouldn't go annywhere near front office, and need to get reconciled to the reported positions;
- Collateral movements need to get reconciled to positions and movements on a daily basis. (I wonder in this case, if there was a collateral call by a counterparty due to the extreme movements in indices or the swissie over August - meaning that cash had to be found when a position apparently "didn't exist"?)
- Cash movements need to get examined - or if it's non-cash (ie. unit creation for ETF's, etc) then the same needs to appply.

(As an aside, the best system I've heard of was where traders daily P&L's had to be explained by virtue of booked trades and macro movements - i.e. two external sources. If there were (sizeable) unexplaineds in either direction - profits or losses - by the time T+2 or T+3 came about, that was when alarm bells were supposed to ring. Must have been hell to explain; but a good control, conceptually.)

Then there's the separation of 'position' and 'hedge'. Delta-1 is where it can all come together - by design, apparently, as that's a part of how they make their turns and their money - but at a people that there needs to be a degree of separation over the trades and the hedges to ensure that both sides are accurate (presumably with the complex systems reconciling it all together). That's a massive simplification - easy when it's 1 trade and 1 hedge; but try it when there's "millions" going on - but if a trader can "control" both sides, it increases the risk of manipulation. In a textbook, there's controls to prevent this, but apparently they weren't working here for some reason.

Lastly, there's the problem of ensuring that all trades actually make it onto the systems. It sounds a bit basic, but so many OTC deals or bespoke instruments get entered off-line and totted up daily, rather than real-time.

(Anyway - ramblings whilst coffee's getting cold. I didn't even get the chance to read the Sundays on this one, but it'll be interesting to hear what went wrong, when it does eventually come out.)

Much obliged to the banking insiders who have posted their thoughts, by the way - invaluable insights!

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emptyend 19th Sep '11 11 of 18
3

In reply to kirkie001, post #10

A common link in some of the most recent large incedents (as has been mentioned) is knowledge of the back-office systems by those working in the front office. At UBS, I've seen it said that their 2008-9 'cost cutting' involved letting a lot of front-offfice staff go, and promoting others (inc trade support) into front-office.

There needs to be an institutional-wide ban preventing middle and back-office staff from moving into front office at the same organisation.

Just on that point, I'd say it is rather too harsh. Certainly it would deprive back-office people of a potential career path and lead to an even lower quality of staff in back-office (apologies to the back office for my obvious front-office bias!).

There does, however, need to be a very clear firewall between the two (avoiding the "Leeson bridge" problem). There is no need for front office to get any confirms directly.

Very good comments re collateral (quite a likely trigger, I agree) and the specific "Delta-1" risk....though I can't see why it cannot be overcome:

Lastly, there's the problem of ensuring that all trades actually make it onto the systems. It sounds a bit basic, but so many OTC deals or bespoke instruments get entered off-line and totted up daily, rather than real-time.

In the days when I was responsible for a business area that generated relative low volumes of high-value bespoke matched deals (up to 1998), it was a stock exchange requirement to report those trades within 30-60 minutes (I forget the details). That was a problem, as the securities were newly-created and didn't have pre-existing ISINs.....but the procedures (that I helped design) required the reporting to be handled by the front-office legal team who were documenting the trade - so that everyone in the bank (and market) could be sure that the deals actually existed!  I can't get my head around the fact that it seems that traders can simply create ficticious trades without running through some sort of similar checking process!

rgds

ee

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kirkie001 19th Sep '11 12 of 18
1

Thanks for your thoughts, ee: the practical insight 'from the coalface' is fascinating in terms of tring to understand the 'how'.

Pestowire has weighed in with his thoughts: http://www.bbc.co.uk/news/business-14968738

His main question apppears to be around the 'why' - with the thrust being that even super-normal profits would have stuck out: therefore how does the individual intend to benefit?

The worrying part would be that the unauthorised activity had apparently (according to the charges laid) been going on in prior years, and not just 2011. So it sounds to me like he's found a way of essentially rolling (probably loosing) positions by being able to creat these fictitious hedges: essentially giving himself access to moro of the bank's capital. I'd assume that he's then been doing this until he gets in a position where he can close out to a "reasonable" profit or loss overall - or at least one that is exaplainable to his superiors, risk and compliance, etc.

But the market movements - equity indices down 15-25% in August; the swissie moving by 8-10% in a single day - meant that he just couldn't hide it any more - it may even have been a gross position that threw up a red flag (even if it appeared to be hedged; the position and the hedge was "too large" in the eyes of someone who tried to understand the rationale for the trade?

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ohisay 19th Sep '11 13 of 18



http://www.guardian.co.uk/commentisfree/2011/sep/19/brain-food-ubs-kweku-adoboli

Has anybody read Lepinays book? It looks like a good read but sometimes these things can be dry as dust..I'd be prepared to buy it on half a recommendation.

http://press.princeton.edu/titles/9618.html

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Isaac 19th Sep '11 14 of 18

There needs to be an institutional-wide ban preventing middle and back-office staff from moving into front office at the same organisation.

Disagree. There have been some good people that have come from the back and middle office that have done very well in the Front Office, not everyone has bad intentions....

I think the solution is front office staff need to be more closely monitored and vetted.

If what you suggested above was the problem and the true cause of the fraud then surely you would expect other institutions to have the same problem rather then just UBS and Soc Gen in more recent years?

How do the likes of Goldmans, Merril, Deutsche etc prevented so far to date these problems?

Maybe because they have more robust systems and more careful vetting of front office staff.

Promoting an open culture and encouraging staff to be vigilant as to what their colleagues are doing and encouriging people to actively 'raise the alarm' is a better approach then preventing back/middle office staff from making progress to the FO.

Not only that segregating the systems so that FO do not have access to MO/BO office systems is also another approach.

If I was the CEO of one of these banks I'd rather have a junior member start in the middle/back office and learn the basics of the business then be thrown in at the deepend in the front office & taking risk and potentially losing a lot of money.

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ExTownie 19th Sep '11 15 of 18
2

In reply to Isaac, post #14

How do the likes of Goldmans, Merril, Deutsche etc prevented so far to date these problems?

Maybe because they have more robust systems and more careful vetting of front office staff. - Isaac

What makes you think that they have prevented these problems?  I  have personal experience of problems like this happening at at least one of those names and I am confident from my time in banking, that they have all had similar issues at some point.    The scale of the losses were just small enough (mostly tens of millions)  to avoid it needing to becoming widespread knowledge.  They all have fairly deep pockets, which helps. 

There have been some good people that have come from the back and middle office that have done very well in the Front Office, not everyone has bad intentions....

While it's true that some good front office people have come from back and middle office functions, there is clearly a risk attached to those transfers.  PersonalIy I think the risk outweighs the benefits as one bad egg has a far greater negative effect than the positive effect of fifty good ones.

Systems do need tightening up, as most would agree, but in practice, it is very hard to get away from the star trader culture where the chosen few become untouchable.  I once worked at a bank where a third of the bank's profits came from a single trader.

 

ET

 

 

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emptyend 20th Sep '11 16 of 18
2

In reply to ExTownie, post #15

What makes you think that they have prevented these problems?  I  have personal experience of problems like this happening at at least one of those names and I am confident from my time in banking, that they have all had similar issues at some point.    The scale of the losses were just small enough (mostly tens of millions)  to avoid it needing to becoming widespread knowledge.  They all have fairly deep pockets, which helps.

Beat me to it, ET.....   ;-)

I once worked at a bank where a third of the bank's profits came from a single trader.

Me too........which is why he subverted all the control mechanisms because everyone's bonuses depended on him!  The top three individual contributions to profit should be quantified in the Annual Report of financial institutions - such concentrations are a MAJOR risk factor.....not only due to fraud but also to the risk that the stars might leave or be overpaid in desperation!

ee

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extrader 20th Sep '11 17 of 18

Hi all,

A bit late to this thread and not sure what I can add in the face of such luminaries....

Granted the difficulty in properly controlling stars 'at the cutting edge', where the gamekeepers will never be as sharp (or as motivated) as the poachers, there's still a lot to be said for the 'smell test'

IIRC, it took an incoming Chairman , looking at Standard Chartered's Indian operation and asking how it was generating 25% (or some such) of the bank's profits on 10% of the assets, to uncover all sorts of shenanigans involving 'Big Bull' Mehta, a major customer who was (allegedly) rigging the stock market, with SC's unwitting help.....

There's plenty of old-fashioned ways of losing money too !

ATB

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Fangorn 21st Sep '11 18 of 18

http://hereisthecity.com/2011/09/21/24-traders-who-were-responsible-for-losing-money/?

Interesting article on the biggest losses incurred by traders.....

Howie is going to take some beating if the est $9bn CDS losses are kosher

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