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Why Didn't Kidder Catch On?


Finance

WHY DIDN'T KIDDER CATCH ON?

Was it simply an isolated incident, a scheme that even the best controls couldn't have detected? Or did it reflect a broad, systemic breakdown?

That is a key issue facing Kidder, Peabody & Co.'s senior managers as they investigate who was behind a two-year, $350 million, phony government bond trading scheme that was disclosed on Apr. 17. Kidder Chief Executive Michael A. Carpenter says he and his top lieutenant, fixed-income head Edward A. Cerullo, were victims of a very sophisticated rogue trader named Joseph Jett, who ran the firm's government bond desk. Jett has been fired, and six other employees were suspended from their jobs. Jett could not be reached for comment.

Carpenter insists that Kidder's controls and risk-management systems are just as good as the rest of the Street's, even though no systems are foolproof: "The altimeter said we were flying at the right altitude, and the compass said we were flying in the right direction, and we banged into the mountain."

RAISED EYEBROWS. Yet many on Wall Street are skeptical of Carpenter's "We wuz robbed" explanation of what is one of the largest Wall Street losses ever. How could the scheme have gone on undetected since 1991? Why didn't 15-year Kidder veteran Cerullo, who was Jett's boss, have a better handle on how Jett was generating "profits" of $20 million to $40 million a month? And most important, are Carpenter and Cerullo to blame for building a culture at Kidder that kowtowed to superstar traders?

John F. Welch Jr., the tough-guy chief executive of General Electric, which owns Kidder, supports Carpenter. "I think, based on everything I know, Carpenter learned of the situation, attacked it vigorously, and has never tried in any way not to get it out," says Welch. "Do I wish he had a nose that had smelled it earlier? Sure. But that's hindsight." GE took a $210 million charge for the Kidder losses on $1.07 billion in first-quarter earnings.

Yet Welch implies that the mess could have been avoided. "Clearly this man [Jett] couldn't do it all alone. People either knowingly made errors or didn't see red flags," says Welch. "No question, when Gary Lynch is through with this investigation, there will be findings" that could lead to further action against employees or their supervisors. Welch is referring to the Kidder-commissioned inquiry being conducted by attorney Lynch.

Lynch is likely to have plenty of questions for Cerullo. A fanatical antismoker who is well-liked and respected at Kidder, Cerullo has had other scrapes with problem traders. In 1991, he was fined $5,000 and censured by the National Association of Securities Dealers for failing to supervise a trader who engineered unauthorized bond transactions. Carpenter backs Cerullo. "He's kicking himself. But I am 100% behind him," says Carpenter. Cerullo declined comment.

MASSIVE POSITIONS. Jett's scheme involved arbitrage trades between the value of pieces of Treasury bonds, called strips, and the recombined bonds. Trouble was, says Kidder, Jett was not generating profit from the slightly greater value of the reconstituted bond, as is usually the practice. Instead, using forward contracts in the strips, he could create much larger bogus profits by exploiting flaws in Kidder's accounting system.

That Jett was allowed to carry out this ploy for such a long time, say Wall Street traders and risk managers, reflects major controls lapses. They claim that if Cerullo truly understood the massive positions Jett must have been taking, he would have questioned Jett about how he was generating such profits. Trading Treasury strips is generally a very low margin area of the fixed-income business, say traders.

Carpenter responds that the profits were not out of line with the real trades on the books and that Cerullo and he were unaware of the phony trades because they accumulated gradually over a period of time. Cerullo "did understand his trading strategy," says Carpenter. But "there didn't seem to be anything terribly out of line. We felt we were running a low-risk, high-margin business."

Kidder may have ignored the lesson learned by Salomon Brothers Inc. in the wake of the 1991 Treasury bond bid rigging scandal: Don't give too much power to traders. When asked whether Cerullo knows how Michael W. Vranos, Kidder's star mortgage-backed trader, generates profits, a senior Kidder official says: "Ed doesn't sit him down and say, `How did you do it this month?"' But you can be sure such conversations with Kidder traders will occur in the future.Leah Nathans Spiro, with Philip L. Zweig, in New York and Tim Smart in New Haven


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