How A Fat Finger At Samsung Securities Committed A $100 Billion Error

It might be the silliest excuse ever concocted by the financial services industry. When someone erroneously authorizes a ridiculously gargantuan trade on a trading platform, the firm blames it on a “fat finger.”

So what on earth is a fat finger? Both literally and figuratively speaking, it’s a sluggish human digit at the end of a hand. Can you visualize someone, with such an extremity, who types too many zeroes into a keyboard?

Earlier this month, a Samsung Securities broker with a fat finger typed an accidental issuance of $100 billion of company shares to employees. By the time the error was detected and reversed, sixteen employees had sold the shares and collected significant proceeds.

Were those employees acting unlawfully? The legal system has not yet determined an answer to that question. But the incident has raised uncomfortable questions about the security of the global financial system.

After all, if a single keypunch error can result in the issuance of $100 billion of shares, how vulnerable is the system to the work of hackers? Or to even larger erroneous — or even intentional — cash disbursement transactions?

Indeed, if we believe that Samsung’s error is merely an isolated mistake, we may be basking in a false sense of security. Perhaps, instead, we should ask how often Samsung’s system of internal control fails to prevent such simple errors.

The Inevitable “Sameness” of Wall Street

Last week, in his final appearance on the television show The Colbert Report, Stephen Colbert reflected on the “sameness” of the political environment throughout the nine year term of his series. “I did more than change the world. I ‘samed’ the world,” he said. “The country isn’t so different than it was in 2005, he reminded us—we’re publicly debating torture, a Bush is running for president, and we’re sending troops into Iraq.”

Mr. Colbert could have easily extended his soliloquy to issues involving Wall Street. Two weeks ago, the government regulator FINRA fined ten banks for engaging in an illegal practice that was first exposed to the public in 1999.

What did the banks do? They utilized their (ostensibly) impartial research analysts to praise Toys ‘R’ Us in the hopes of winning an IPO stock trading contract from the retail giant. The analysts, of course, are responsible for evaluating firms in an objective manner and issuing buy, hold, or sell recommendations to the public.

Back in 1999, a Citigroup analyst named Jack Grubman was caught manipulating his recommendation of AT&T stock so that his firm could win a similar trading contract. In that particular case, though, Grubman did more than earn new business for his employer; his willingness to compromise his impartiality led to a prestigious pre-school’s “quid pro quo” decision to admit his child to its program.

Citigroup’s public embarrassment over the Grubman episode, along with regulatory reforms that were promulgated in the wake of the episode, were supposed to deter research analysts from compromising their ethical standards in the future. But today, fifteen years after the Citigroup fiasco, FINRA’s punishment of ten banks (including, ironically, Citigroup itself) illustrates that the same illegal practice plagues the industry.

Thus, as Mr. Colbert might say, the financial industry is still “saming” the world with its ethically questionable activities. Fifteen years of boom, bust, recovery, and regulation haven’t compelled the institutions to change their practices at all.

Bank Regulation: Rolling Backwards

Are you clinging to the hope that the 2008/09 crash of the global economy was the last one that we’ll experience in our lifetimes? Do you believe that our political leaders learned much from the events that almost destroyed the world’s financial system?

If you remain optimistic about our economic future, you might wish to ponder legislation that was approved by the United States Congress last week. Legislators easily passed a bipartisan federal budget that funded the operating activities of the United States and avoided any possibility of another imminent government shutdown.

That sounds very promising, doesn’t it? After all, any bipartisan activity in Washington can be a cause for celebration. And any budget process that avoids a federal government shutdown can represent a step in the right direction.

But before you permit yourself to feel optimistic about the future, you might wish to read the “fine print” of the budget bill. If you do, you’ll notice that an important component of regulatory oversight, one that was instituted by the Dodd Frank Act just a short time ago to prevent a future government bail-out of the “too big to fail” banks, is being dismantled.

Lobbyists from the global bank Citigroup reportedly helped write the provision that repeals restrictions on the riskiest investment activities of federally insured banks. On a go-forward basis, the new law “will allow banks covered by the Federal Deposit Insurance Corporation to directly engage in derivatives trading.”

In other words, as a result of this law, the world’s largest American banks will again be empowered to trade in the very derivatives that Warren Buffet once called “financial weapons of mass destruction.” And the institutions that engage in these trades will retain the benefit of insurance coverage by the taxpayer supported FDIC.

Will this new law encourage riskier behavior by America’s banking giants? And will it again create the very conditions that might lead to the next global economic collapse? The sudden roll-back of the derivative regulations that were first passed only four years ago makes it difficult to be optimistic about the future stability of the global financial system.

The World of Chinese Finance

Of all the landmark laws that were passed during Franklin Roosevelt’s “New Deal” presidency of the Great Depression, the Banking Acts of 1933 and 1935 may have helped the most to stabilize the American financial system. After all, those were the laws that created a national system of deposit insurance to be managed by the fledgling Federal Deposit Insurance Corporation (FDIC).

The system of insurance eliminated the risk of bank failures from the minds of most depositors by creating a legal guarantee that their funds would be insured by the “full faith and credit” of the federal government. The system was lauded, and is still praised, as a critical component of the American “safety net” that ensures the security of bank deposits.

Last week, the Chinese government proposed its own national system of deposit insurance, one that would insure up to 500,000 yuan (i.e. approximately $81,000 at current exchange rates) per bank. Oddly enough, though, the proposal was perceived as an attempt to inject more risk into the banking system.

More risk? How can the introduction of an insurance program create more risk? And why would the Chinese government seek to inject more risk into its banking system?

Apparently, Chinese citizens and businesses now assume that their government will insure all deposits at state-controlled banks. Just as many Americans have come to believe that certain banks are “too big to fail” and will always be bailed out by the federal government, their Chinese counterparts similarly believe that all of their banks will always be bailed out.

Thus, by introducing an explicit limit of 500,000 yuan, the Chinese government isn’t simply adding a new and explicit system of limited deposit insurance. Rather, it is actually replacing an existing, implicit, unlimited system of insurance with one that is new, explicit, and limited in nature.

And why would Chinese government officials wish to do that? Unlike President Roosevelt, who was faced with the challenge of regulating a banking system that had traditionally operated without any government oversight, Chinese leaders are now confronted with the task of deregulating a banking system that had traditionally been managed by Communist government officials.

In other words, in a free market economy like America’s in the 1930s, the federal authorities must focus on reducing excessive market risk. But in a government managed economy like China’s in the 21st century, the federal authorities must focus on increasing market risk.

Given that distinction, it is ironic that the Chinese government is now adopting an insurance framework that is similar to the one that President Roosevelt implemented during the 1930s. Both cases, though, involve government officials who are employing a program of deposit insurance in order to achieve an optimal level of market risk in the banking sector.

Britain’s Timeless Debt

How long should you wait before “writing off” an old unpaid debt? If the borrower is Great Britain, the answer is undoubtedly “a very, very, very long time.”

Why? Because last week, the federal Treasury of the United Kingdom announced that it would soon pay off almost $350 million of old government bonds.

How old? Chancellor of the Exchequer Winston Churchill first issued the bonds in 1927. But his 1927 offering actually contained refinanced bundles of significantly older debt. Much of it originated during the First World War, and some of it dated from the South Sea economic crisis of the 1720s and the European Crimean War of the 1850s.

The debt still carries an annual interest rate of 4%, and maintains a perpetual (i.e. no maturity date) term. But it is “callable” (i.e. it can be paid off) at any time by the British government; the recent decline in global interest rates has compelled the Treasury to liquidate it.

This isn’t the only historical instance, though, of the British government enjoying an astonishingly good deal on financing terms. For instance, from 1898 to 1997, it held a rent-free lease from the Chinese government on all of Hong Kong.

And during the Second World War, via America’s “Lend Lease” program, the United States sent weapons to Great Britain to fight the Nazi regime. The British government made its final payment on this debt in 2006, incurring an annual rate of 2% throughout the loan period.

Perpetual bonds exist in the corporate world as well. But most investors consider them to be extremely risky securities; they usually demand very high interest rates to compensate for the limitless maturity dates. And certain global banks have classified them as equity instruments (i.e. debt in name only) for purposes of meeting their Basel III capital reserve requirements.

So did investors effectively purchase an equity interest in the British Empire when they first “loaned” Churchill the callable perpetual funds in 1927? Perhaps so, but during the 1920s, the Empire must have represented an extremely attractive investment opportunity to those investors.

After all, Britain governed more than 20% of the world’s total land at that time. Its empire stretched from Africa (e.g. South Africa) to Asia (e.g. India) to the Pacific (e.g. Hong Kong and Singapore) to the Americas (e.g. Guyana). And it nurtured close economic relationships with Australia, Canada, and the other future members of the Commonwealth of Nations.

Today, though, the British Empire’s possessions have dwindled down to a handful of island territories. And even New Zealand is moving towards full independence by debating the removal of the Union Jack from its national flag.

So what investment lesson can we learn from the lenders who agreed to invest in the British government in 1927, and who are finally being repaid this year? Perhaps it is this: we should always think twice before entering a financial commitment with no exit strategy in mind.

And perhaps that lesson applies to all other commitments, too.

Basket Options: Wall Street Launders Again!

Have you noticed that the financial wizards of Wall Street tend to implement the same strategies over and over again?

During the late 1980s, for instance, financial institutions turned high-risk “junk bond” debt into a staple of corporate finance. And two decades later, many of the same organizations churned out “sub-prime” mortgage debt securities.

Here is another example: during the 1990s and early 2000s, investment bankers helped American corporations reduce their tax burdens by advising them to move their headquarters to nations with lower rates of taxation. Today, of course, their “tax inversion” acquisition strategy is following the same path.

And a few days ago, the United States Senate held an investigatory hearing into yet another questionable Wall Street strategy. This one, called the basket option, operationalizes the time-tested principles of money laundering.

Money laundering? Isn’t that illegal? Well, when firms launder funds through intermediary organizations to hide criminal activities, it is most certainly illegal.

But what does “money laundering” mean? For a simple example, let’s assume that the owner of a criminal syndicate earns significant amounts of cash from illegal narcotic or prostitution activities. Let’s also assume that the owner decides to purchase an empty strip of land and operate a parking lot.

Why would he do so? Because parking lots are cash businesses. The owner will deposit his illegal business cash receipts into a bank account that serves his legitimate parking business, while attributing those receipts to parking services. In essence, the owner will use the parking lot to “clean” (or “launder”) his “dirty” illegal money by attributing it to a legitimate business.

Wall Street’s basket option strategy utilizes the same principle. Instead of trading securities on a continuing basis, an American investor will contract with a financial institution to create a “basket” of securities that trades frequently on his behalf. The investor will also hold an option to purchase (or sell) the basket, and will exercise that option on an infrequent basis.

How infrequently? Invariably, he will exercise his option less frequently than once a year. Why not more often? Because more frequent trading would defeat the purpose of owning the basket option.

You see, if an American investor sells a security that is owned for less than a year, he would pay a relatively high “short term capital gains” tax rate on his profit. But if he sells a security that is owned for more than a year, he would pay a much lower “long term” rate.

Thus, by relying on a different entity to make short term trades while transacting with that entity on a long term basis, the investor can utilize the entity to “launder” those short term trades and redefine the resulting profits as long term profits. And by doing so, the investor can reap the benefit of the lower tax rate.

This laundering strategy, incidentally, is reminiscent of an incorporation structure that Goldman Sachs proposed to Facebook before the social media giant “went public” in an Initial Public Offering. Apparently, Facebook’s corporate officers decided to go public because the firm was about to expand its investor roster to more than 500 individuals, a level at which any American firm must accept (by law) the regulatory burdens of public ownership.

Goldman, however, proposed to create a Special Investment Vehicle (SIV) to serve as the sole owner of Facebook stock. This holding company, according to Goldman, would then resell that stock to far more than 500 investors.

Such a strategy, in essence, would have permitted Facebook to rely on a new entity to “launder” large numbers of investors into a single unit for the purpose of avoiding the responsibilities of public ownership. To its credit, Facebook declined to accept Goldman’s offer and decided to launch its Initial Public Offering instead.

Nevertheless, this strategy of “laundering” transactions through an intermediary entity appears to have been employed again in the form of today’s basket options. Apparently, Wall Street’s wizards of finance cannot resist the temptation to utilize intermediary organizations to “clean” transactions, a strategy that they implement over and over again.

Wall Street and the Pac-Man Defense

Do you remember Pac-Man? A Japanese company named Namco first released the rudimentary video game in May 1980, several months before Ronald Reagan was elected President of the United States for the first time. It quickly became an iconic product of the 1980s, and one of the most widely celebrated video games in history.

Oddly enough, the Pac-Man game has reappeared in the news recently, thrust into the headlines by a classic Wall Street corporate battle. Six weeks ago, a relatively small but venerable men’s fashion retailer named Joseph A. Bank Clothiers dropped its hostile takeover bid for Men’s Wearhouse, a larger discount clothing outlet.

So how did the board members of Men’s Wearhouse respond to this unwelcome suitor after Bank dropped its bid? One week later, the board members turned the tables and launched their own hostile takeover bid for Bank!

At that bizarre moment when the hunter became the hunted, Bank suddenly found itself in a defensive crouch. And now Bank is striving to avoid the very merger that it had previously espoused, when it initially played the role of the stalker and not of the target.

This Men’s Wearhouse strategy is known on Wall Street as the Pac-Man Defense. Its name refers to the brief moments in the video game when the gamer’s Pac-Man avatar is suddenly blessed with the ability to “gobble up” its ghostly enemies Inky, Blinky, Pinky, and Clyde, and is no longer forced to flee from them. During those moments, Pac-Man reverses course and pursues the four “would be” hunters.

Wall Street first developed the Pac-Man defense in the early 1980s, at a time when the video game was achieving its heights of popularity. The 1982 Martin Marietta – Bendix Corporation takeover battle represented the first application of the strategy.

Interestingly, many financial analysts believe that today’s proposed merger of Bank and Men’s Wearhouse, a men’s fashion retailer and a complementary discount clothing outlet, is a sensible one. And Bank is not arguing the point; instead, it is claiming that the Men’s Wearhouse acquisition offer does not fully reflect the value of the Bank franchise, repeating the very claim that Men’s Wearhouse previously made about Bank’s previous offer!

In other words, the Pac-Man offer / counter-offer process appears to represent an incredibly elaborate (and thus extremely costly) passive – aggressive mating dance between two compatible organizations that have already accepted the logic of a business combination.

But then why waste all this effort on the dual takeover battles? Why not simply ask the board members of the two firms to either hash out a deal, or to forget about it?

Wall Street does not appear to have an answer to this question. Thus, the mating dance continues unabated.

If you were a board member of Joseph A. Bank, what would you do?