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-------------------------- source: Bloomberg ----------------------------
Societe Generale, Mergers Weakling, Leads in Equity Derivatives
2005-11-27 20:55 (New York)
By Jacqueline Simmons
Nov. 28 (Bloomberg) -- Societe Generale SA, the French
retail bank created under Napoleon III, put two employees to work
in an office a block from the Galeries Lafayette department store
in central Paris in 1985.
Two decades later, the team numbers 2,000 people in 60
countries.
In a bustling trading room that links the bank's 36- and 37-
story office towers overlooking the French capital, traders and
salespeople sit in orderly rows. From 8 a.m. to 10 p.m., when
work shifts to other markets, they design, sell and trade some of
the hottest and most complex instruments in international
finance: equity derivatives. Investors buy the securities, whose
value is based on a stock or index, to cushion their holdings
against unexpected market swings.
Societe Generale takes in more money selling equity
derivatives than any other bank in the world: as much as $2
billion in revenue in 2004, according to estimates by Merrill
Lynch & Co. and Morgan Stanley. The bank has deployed
mathematics-savvy recruits to become a leader in the lucrative
niche. It fashions ever-more-intricate derivatives -- too
intricate, some clients say -- and offers them to banks and
individuals worldwide.
``They've got massive scale, and scale is a barrier to entry
in equity derivatives,'' says Kinner Lakhani, a banking analyst
in London for Amsterdam-based ABN Amro NV. ``Beyond that, it's
their intellectual capital, a function of the presence they have
in Paris, and grads coming out of math colleges in France. Their
existing franchise has been ahead of the curve on all of this,
and they innovate on a monthly basis.''
First-Half Spurt
The growth continues. In the first half of 2005 alone,
equity derivatives generated about 1.3 billion euros ($1.54
billion) of revenue for Societe Generale, London-based Morgan
Stanley analyst Stephen Jarvis estimates.
Equity derivatives typically are options -- contracts that
give an investor the right, though not the obligation, to buy or
sell a security or index at a given price at some future date. A
put option affords the right to sell; a call option gives the
right to buy.
Just as an insurance policy protects against an accident,
options let investors hedge against an unexpected rise or fall of
a security or index, such as the plunge in technology shares that
sent stock markets sliding in 2000.
``Demand accelerated massively when you had the bubble
bursting in 2000, and investors became a lot more skeptical about
the overall returns of the stock market,'' says Vasco Moreno,
head of European bank research at Keefe, Bruyette & Woods Ltd. in
London.
$8 Trillion Market
As investors ranging from pension and hedge funds to wealthy
individuals look for ways to safeguard their investments, the $8
trillion equity derivatives market is booming. Of the $184
billion in investment banking revenue the world's banks reported
in 2004, equity derivatives contributed $14 billion, or 7.6
percent, according to an Aug. 23 report by Boston Consulting
Group Inc. That may increase to $20 billion by 2007, the study
said.
The notional amount, or face value, of equity derivatives
traded over the counter -- not the money that changes hands but
the amount buyers and sellers use to calculate eventual payoffs -
- almost doubled to $4.39 trillion in 2004 from 2002, according
to the Bank for International Settlements in Basel, Switzerland.
For exchange-traded derivatives, the amount nearly doubled in two
years, to $3.7 trillion, the BIS says.
Annual Fees
Societe Generale makes money in derivatives by trading with
its own capital, trading options for clients and charging fees to
investors. Banks producing structured products -- derivatives
that usually combine a bond with an index option -- charge an
annual fee of 0.10 percent to 0.20 percent of the value of the
derivative, depending on the complexity and risk involved, says
Dixit Joshi, head of equity derivatives at the Barclays Capital
unit of London-based Barclays Plc.
The bond in a structured derivative guarantees payment of at
least the initial investment at maturity. That means investors
can do no worse than get their money back at the completion of
the contract and may have gains, based on the performance of
indexes or individual stocks.
To determine the value of a structured derivative in order
to set a fee, banks use a formula that includes the price of the
stock or index, interest rates and measures of market volatility,
among other factors.
`Strong Skills'
``Societe Generale decided quite early on that equity
derivatives was an area they wanted to focus on and took on a lot
of people with strong skills,'' says Donald Linderyd, an analyst
at London-based Merchant Securities. ``They've distanced
themselves quite considerably from the American, U.K. and German
investment banks.''
Societe Generale said Nov. 17 that third-quarter net income
rose 40 percent to 1.13 billion euros, ahead of analysts'
expectations, as revenue from the equities and advisory business,
which includes derivatives, increased by a quarter to 694 million
euros.
It was the best third quarter ever for equity derivative
sales at the bank, says Christophe Mianne, 42, who has run
Societe Generale's equity derivatives unit since 1999.
Societe Generale's sprint to the top in equity derivatives
is more than an example of French agility among heftier U.S.
investment banks. It also reveals how a nation's focus on
mathematics education can pay off for bankers.
Stochastic Calculus
To engineer options-based contracts, Societe Generale has
hired employees schooled in everything from partial differential
equations to probability concepts like stochastic calculus and
Brownian motion. The bank added computer systems fast enough to
process risk models in real time during the trading day. Societe
Generale says it invests more than 100 million euros a year -- 3
percent of its 2004 earnings -- on such information technology,
or IT.
``The French banks are ahead because of their experience,
technical expertise, platforms, quantitative capabilities and IT
infrastructure, which are second to none,'' says Bahadour Moussa,
a recruiter who focuses on derivatives specialists at London-
based executive search firm Huxley Associates. ``A U.S. bank that
wants to replicate this now would need to make massive
investments into new technologies, platforms and people.''
While the higher math allows Societe Generale to craft
customized hedging strategies, the complexity can be baffling and
risky, specialists and regulators say.
`Can Be Risky'
``I can't find a good motivation for this complexity,'' says
Nicole El Karoui, who has trained students for finance jobs as a
professor of applied mathematics at Ecole Polytechnique, France's
premier science and engineering graduate school. ``There's a
responsibility to explain that, in fact, the product can be too
risky and difficult to analyze.''
U.S. regulators say equity derivatives may not be
appropriate for anyone other than the savviest investor.
Washington-based NASD, formerly the National Association of
Securities Dealers, in September issued a report to members
expressing concern they may not be adequately explaining to
investors how much can be lost if things go wrong.
Jacques Verdier, a fund manager at Paris-based Banque de
Neuflize, a unit of ABN Amro, says that fathoming some of the
offerings is a challenge.
``SG's team has a technical level that is very high,
sometimes too high,'' he says. ``We don't always have the means
to understand these products or appreciate them enough, so we
haven't always wanted to invest.''
`Dangerous Game'
The real risk arises when customers don't grasp how the
instrument works, says John Osborn, head of the derivatives
practice at New York law firm Skadden, Arps, Slate, Meagher &
Flom LLP.
``The products themselves are neutral,'' he says. ``It's
just a question of getting people into what they know and
understand.''
There are risks, as well, for the banks selling equity
derivatives, ABN Amro's Lakhani says. ``If you don't get the risk
right, it's an extremely dangerous game to be in,'' he says.
In September, Credit Industriel & Commercial, or CIC, the
investment banking arm of Paris-based Credit Mutuel, said it had
one-time losses of 320 million euros on equity derivative-related
contracts for the six months ended on June 30. In June, the bank
had said on its Web site that the losses came from the sale of
``potential risks'' on structured derivatives, giving no details.
In 2004, the bank's net income was 550 million euros.
Two Losing Months
Jean-Pierre Mustier, the head of Societe Generale's
corporate and investment banking unit, says his bank has had only
two losing months in equity derivatives in the past 15 years.
Corporate and investment banking accounted for 44 percent of
Societe Generale's 3.3 billion euros of earnings in 2004.
``I'm not saying we make money every day,'' says Mustier, a
former derivatives trader who turns 45 in January.
Societe Generale started trading equity derivatives almost
20 years ago partly because it was late investing in the
personnel required to compete with its U.S. rivals in the
profitable fields of mergers advice and stock underwriting.
``French banks were considered weak in investment banking,''
says Antoine Paille, who originated Societe Generale's equity
derivatives effort in the mid-1980s from the office near Galeries
Lafayette.
In corporate and investment banking, a category commonly
used by banks to show financial results in underwriting, mergers
and other areas, including equity derivatives, Societe Generale
trails the leaders. Its corporate and investment banking net
income for 2004 was 1.45 billion euros.
BNP Paribas No. 2
By comparison, New York-based Citigroup Inc. earned $6.4
billion. In France, Societe Generale lagged Paris-based BNP
Paribas SA in 2005 in bond underwriting, mergers advice and
syndicated loans in late 2005, according to data compiled by
Bloomberg. Merrill Lynch analyst Jacques-Henri Gaulard ranks BNP
Paribas, Europe's fourth-largest bank, second in the world in
annual revenue from equity derivatives, with about $1.2 billion.
``There's no question that SocGen and BNP are very strong in
equity derivatives,'' says Joseph Elmlinger, head of global
equity derivatives at Citigroup. ``Why? They started early,
committed a lot of resources to it.''
That has allowed the French banks to build a reputation that
attracts the best job candidates.
``When I was a young engineering-school student, I thought
the best banks were American ones like Goldman or Morgan
Stanley,'' says Marc Atlan, 26, who is completing his doctorate
at the Universite Pierre & Marie Curie in Paris on finance-
related probability theory while working in BNP Paribas's
derivatives department. ``Later, I realized that for equity
derivatives, BNP and SG were the best in the world.''
Shares Rising
Shares of Societe Generale surged 38 percent in the 12
months ended on Nov. 25, to 101.90 euros, amid growth in retail
banking in Eastern Europe and in equity derivatives. In the same
period, the 78-member Bloomberg Europe Banks and Financial
Services Index rose 23 percent. Among the 39 analysts who follow
the stock, 16 rate it ``buy'' and 14 rate it ``hold.''
One with a ``hold'' rating, Guillaume Tiberghien at Deutsche
Bank AG in London, says corporate and investment banking performs
well at Societe Generale yet has a limited focus: derivatives,
capital markets and structured finance, which includes private
equity and commodities. ``Such a narrow focus may make the bank's
earnings more volatile,'' Tiberghien says.
Societe Generale plunged into the esoteric realm of
derivatives soon after it hired Paille in 1984. He was 29, a
former computer-services specialist and a graduate of France's
top statistics school, Ecole Nationale de la Statistique et de
l'Administration Economique, or Ensae, located just outside Paris.
Options fascinated him.
`Transform' Banking
``Options seemed to unite math, statistics and computers,''
Paille recalls. ``I felt this was an area that would transform
the banking environment, and I didn't want to copy what other
banks were doing.''
With the blessing of Jean-Bernard Guillebert, who helped
oversee Societe Generale's capital markets group, Paille started
an options division by focusing first on currencies. His timing
was good. In 1985, the U.S. dollar fell against the French franc,
deutsche mark and Japanese yen, aided by a coordinated effort
among central banks under the Plaza Accord announced that
September.
France's equivalent of the U.S. Export-Import Bank, known as
Coface, sought bids from banks to help offset bad currency bets,
according to Paille. Societe Generale won the bidding, and Paille
oversaw the contract, which involved trading options on the
dollar.
Grandes Ecoles
``That was the deal that really kicked us off,'' Paille says.
Paille followed with options on interest rates and then
equities. He needed a custom-designed computer program, and he
needed brainpower. For both, he turned to the postgraduate
programs at Ecole Polytechnique and Ecole Centrale Paris. Created
in 1829, Ecole Centrale trains industrial engineers. Its alumni
include people named Michelin and Schlumberger.
Both institutions are among France's Grandes Ecoles, the
state-financed graduate schools that produce the nation's
managerial class and political elite.
``We went across the campuses of the Grandes Ecoles pitching
our business,'' Paille says.
In 1987, he expanded the team to include quantitative
analysts, then traders. ``My project was to create an area of
strength within the bank,'' Paille, now 50, says. ``Our strategy
was to be a world leader.''
Inaugural Trade
Among the young graduates he hired was Mustier, who had
taken classes at Ecole Polytechnique before transferring to Ecole
des Mines, another of the Grandes Ecoles in Paris that focuses on
science and technology.
Mustier descended onto the floor of the Paris bourse on the
morning of Sept. 10, 1987, to execute Societe Generale's
inaugural trade in equity derivatives. He was 26.
``We were dead scared,'' he recalls. Before him stood a
horde of U.S. and Canadian dealers posted to Paris by their banks
as the bourse's market for listed options, called the Monep,
opened for business. The traders were hand signaling orders with
a mere flick of the wrist. It was intimidating.
``We had an Anglo-Saxon complex,'' Mustier says, using a
term common among the French to refer to the English-speaking
world's culture, wealth and influence. ``We really wanted to be
as good as the American banks.''
Five weeks later, the move into equity derivatives passed a
crucial test. On Oct. 19, the Dow Jones Industrial Average
plunged 23 percent, and world markets followed. Mustier's options
trades, many of which bet on market fluctuations rather than
simple appreciation, helped Societe Generale make money during
one of history's greatest market jolts.
Global Presence
Paille and his team acted quickly to build a global presence.
In 1989, Mustier moved to the U.S. to develop trading there,
including currency options on the Philadelphia Stock Exchange.
After a brief stint in Frankfurt, he was named head of options in
Tokyo in 1991.
By the early 1990s, competitors were hiring away too many
derivatives employees, Paille says, and Societe Generale rejected
his plan to give them a direct stake in the business. He left the
bank in 1993 for Frankfurt to set up Commerzbank AG's derivatives
unit.
Societe Generale then created a separate unit for equity
derivatives, removing it from the options group, and installed
Mustier as the global head of the new division. Later, Mustier
moved to Hong Kong and rolled out derivatives trading there with
Luc Francois, then head of equity derivatives in Japan.
Lyxor Unit
In 1998, Societe Generale created Lyxor Asset Management to
offer derivative-related instruments in the form of a fund and to
provide options and other derivatives on hedge funds. Lyxor was
also formed to independently monitor and value the external hedge
funds' investments, giving the bank's clients more control over
their risks.
That same year, Societe Generale came out with its so-called
Mountain Range derivatives. The initial product was named Everest.
It was sold to private banks and allowed an investor to bet on
the performance of a group of stocks.
Under a contract with a 10-year term, Everest promised to
double the initial investment, plus return an amount based on the
performance of the weakest stock in the basket. If the weakest
performer was flat, investors doubled their initial investment at
maturity. If the poorest-performing company went bankrupt, only
the initial investment was returned. If the weakest stock doubled,
investors got three times the initial investment.
No Interest, Dividends
The risk for investors was that only the guaranteed capital
might be returned -- not interest and dividends they might
otherwise have gotten. A further risk arose if the bank selling
the derivative entered bankruptcy.
In 2000, Societe Generale opened Inora Life, which sells
life insurance policies whose premiums are invested in
derivative-related instruments that provide an added payoff and
allow clients in some European countries to claim a tax deduction.
The bank also launched an online service, ClickOptions.com,
aimed at letting individual investors buy options contracts based
on specific market scenarios extending for up to six weeks. An
investor who thought France's CAC 40 Index would rise to a
certain level on a specific day could buy an option on that
scenario for 40 euros. If it materialized, the investor got 100
euros; if not, the 40 euros was lost.
Over the years, Societe Generale's derivative offerings have
expanded beyond standard contracts, often called plain-vanilla
options, to more complex, so-called exotic instruments. In an
exotic option, the payoff is either linked to several securities
or depends on how a security or index performs before the
instrument matures.
Worst Performer
In the first case, the worst performer in a basket of stocks
may determine the derivative's value at maturity. In the second
case, the bank may place a cap on the monthly return from the
stocks -- 3 percent per month, or 36 percent a year. The floor
might be set at zero, meaning the investor wouldn't lose any
principal should the index decline.
Paul W****tt, a London-based consultant, says the complexity
is unnecessary. ``I see so many of the term sheets for exotic and
structured products and wonder, Who's interested in these
things?'' says W****tt, the author of ``Derivatives: The Theory
and Practice of Financial Engineering'' (John Wiley & Sons, 199 Cool .
``More than half of them are made for the sake of saying, `We're
more clever than you.'''
Complicated Ones
Many of Societe Generale's instruments, even complicated
ones, give investors at least part of their principal back in
case of a crash, says Bernard Desforges, who heads equity
derivative sales and structuring at the bank. London-based GLG
Partners LP, Europe's largest hedge fund firm, and the wealth-
management unit of Zurich-based Credit Suisse Group are among the
Societe Generale clients that have used structured derivatives.
Societe Generale customized an equity derivative for a
European insurer in 2004 that consisted of two products the
insurance company could sell to clients. To guarantee the initial
capital at maturity, both included a zero-coupon bond -- a bond
sold at a deep discount to its face value, paying no annual
interest and maturing at its face value.
In one, a 10-year call option gave customers the right to
buy shares linked to a basket of 15 international stocks. In
another, the call was linked to a European index. The products
guaranteed investors their entire initial capital plus a
predetermined percentage based on the performance of the shares
or index. The investor risks getting only the guaranteed capital
-- not interest and dividends.
Ready Talent Pool
French banks seeking the right people to build and price
derivatives have a ready talent pool. The national mathematics
curriculum is rigorous. By age 16 or 17, students are choosing a
specialty so they can enter preparatory classes needed to sit for
entrance exams for the Grandes Ecoles. The more technical among
them form a feeder system for French banks.
``They were eager to enter the real world, meaning apply
academic and scientific backgrounds to build a project and be
judged by its success,'' Paille says of his early recruits. In
one two-year span, he hired half of all the applied math
graduates of Ecole Centrale, or 30 recruits.
To select the best Grandes Ecoles candidates, French banks
offer internships in Paris or yearlong stints at foreign
subsidiaries.
``These graduates typically come from Ecole Polytechnique;
Ecole Centrale; the statistics school, Ensae; and other top
engineering schools,'' recruiter Moussa says. ``They are the
backbone of all the research produced by SG. Pricing exotic
equity derivative options requires impeccable financial
mathematics.''
BNP Paribas
Across town in the Opera district of Paris, rival BNP
Paribas hires many of the same graduates as Societe Generale.
``The staffs probably have the same profile, coming from the
same schools and recruitment processes,'' says Olivier Osty,
global head of equity derivatives trading at BNP Paribas.
Non-French companies recruit as well. Each October,
representatives from banks such as New York-based Lehman Brothers
Holdings Inc. and Barclays Capital turn up at Universite Paris
Dauphine's campus on the western edge of the French capital to
begin courting potential interns, says Helyette Geman, a finance
professor at the school.
France's mathematics tradition has a direct link to finance.
Louis Bachelier, who examined options pricing in his 1900
dissertation ``Theorie de la Speculation,'' is considered one of
the founders of financial mathematics. He was the first to apply
Brownian motion -- models used to describe random movements, such
as particles in a fluid -- to stock-market fluctuations.
`Trained to Do That'
Alexandre Fleury, head of European structured-products
trading at Societe Generale, says the French have distinguished
themselves in equity derivatives because their love of
complicated math allows them to take more risks.
``We're just trained to do that,'' he says.
Societe Generale's rivals say they plan to catch up. BNP
Paribas and Barclays Capital are looking to the U.S. More
investors in the U.S. are turning to equity derivatives as they
near retirement to ensure they can weather another stock-market
slump, says Santosh Nabar, a managing director at JPMorgan Chase
& Co. in New York.
Another competitor, Paris-based Credit Agricole SA, France's
biggest bank by assets, hired Marc Litzler, a 13-year Societe
Generale veteran, to help spearhead expansion of its investment
bank, Calyon.
``We are a French bank and have a competitive advantage in
that all of the good equity derivatives people are here,'' says
Litzler, who made the switch in 2004.
Anglo-Saxon Complex
Mianne, the head of Societe Generale's equity derivatives
unit, says personnel turnover in the past three years ranges from
6 percent to 10 percent. The unit hired about 100 professionals a
year over the last three years, including traders, salespeople,
and quantitative researchers, and expects to hire about 125 in
2005, he says.
Mianne's boss, Mustier, expresses confidence about the
future, even as more banks gear up to compete in the U.S. and
Europe -- and poach key executives.
The market is so large and Societe Generale has been at it
for so long, compared with rivals, that it will be difficult for
others to close the gap, Mustier says.
His self-diagnosed Anglo-Saxon complex was cured years ago.
To better pursue Societe Generale's strategy for European growth,
Mustier moved to London in 2001.
--With reporting by Justin Baer in New York. Editors: Horvitz
(rah/awj)
Story illustration: Click on {GLE FP
history of Societe Generale earnings. To chart the performance
of the shares, click on {GLE FP
about France: {TOP FR
Pierre Mustier, head of Societe Generale's Corporate and
Investment Banking unit, go to {BBDP 1746493
To contact the reporter on this story:
Jacqueline Simmons in Paris at (33) (1) 5365-5055 or
jackiembloombergnet.
To contact the editor responsible for this story:
Ronald Henkoff at (1) 212) 318-2347 or
rhenkoffbloombergnet
