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They Said, He Said At Kidder Peabody


Finance

THEY SAID, HE SAID AT KIDDER PEABODY

The Kidder, Peabody & Co. trading scandal has not always been easy to follow. Yet amid the welter of charges, countercharges, forced resignations and general trauma, two alternate versions of reality have been emerging. Kidder claims that Kidder Treasury bond trader Joseph Jett, unbeknownst to superiors, conducted a series of phantom trades that caused Kidder parent General Electric Co. to report a $210 million loss. Jett claims that his trading was directed by senior executives.

Now, the conflict seems to be coming to a head. Kidder's internal investigation of the fiasco by attorney Gary G. Lynch is due to be released in the first week of August. His conclusion is expected to support Kidder's position. Lynch declined comment.

Jett, meanwhile, has been telling his side of the story to the office of the U.S. Attorney for the Southern District of New York. People who are familiar with his account say he claims that the main purpose of his trades--which involved "stripping" Treasury bonds into separate interest and principal payments, doing "forward" trades of the strips, and then "reconstituting" those strips back into bonds--was to reduce the assets on Kidder's bloated balance sheet to comply with limits mandated by GE. These trades, though, depleted his inventory of Treasury bonds. Jett is saying that he then engaged in a series of "profit-neutral" trades to recover his inventory. Jett is alleging that the elaborate scheme was invented by fixed income chief Edward Cerullo. The U.S. Attorney's office had no comment.

"PREPOSTEROUS." Kidder disparages

Jett's version. "The notion that Mr. Jett engaged in his forward strip and recon trades for the good of the firm is preposterous," says John M. Liftin, Kidder Peabody's general counsel. Liftin says the forward trades were done "solely to create the appearance of profit for Mr. Jett's benefit."

Cerullo also strongly rebuts Jett's allegations. "To think I went to Joe Jett and said this is how you do it [shrink the balance sheet]--absolutely, positively not," says Cerullo.

Jett has refused to talk to Lynch, says George Sard, Jett's spokesman. Lynch is representing Kidder in salary arbitration against him.

But the Lynch report will undoubtedly carry far more weight than Jett's recollections. Lynch has Kidder's trading records, not to mention exhaustive testimony, to back up his findings. And even if Lynch is being paid by Kidder, his sterling reputation is on the line (box). Jett, in contrast, does not even have his red book, the handwritten record of the trades in his government-bond trading area, say sources. Further, Jett is a loner who appears to have few allies to corroborate his story.

Still, while there are some serious flaws in Jett's story, which has not been told in detail before now, in some respects it seems plausible and jibes with some comments from Kidder executives. Kidder, for instance, acknowledges that it "sometimes takes steps to bring [the size of its balance sheet] into line with management's view of appropriate levels." Kidder says this is "perfectly legitimate."

Jett's account, say people who have talked to him, begins a year ago. Before the end of the third quarter of 1993, he says, Cerullo came up with a complex way to shrink assets by reconstituting Jett's inventory of strips into bonds. Because of the peculiarity of Kidder's accounting system, sources say, about $20 billion in strip assets were converted to $5 billion in bond assets through recon trades. That's because both principal and future interest payments of strips had to be accounted for on the balance sheet while only principal amounts had to be accounted for in valuing bonds.

But that left Jett with a problem. To do business with customers who buy strips, he needed to get his strip inventory back. This is why in Jett's account he was allowed by superiors to do a second series of trades. One trade involved selling strips forward, or for future delivery. This converted Jett's $5 billion inventory of bonds back into his $20 billion in strip inventory. These trades generated paper losses. But these losses were offset. Jett at the same time bought forward a number of recon trades, which generated paper profits.

Although the scheme worked for the third quarter of 1993, according to Jett's account, troubles arose during the next two quarters. Cerullo asked Jett to reduce his strip inventory by about $15 billion to avoid asking the highly profitable mortgage-backed securities operation to liquidate assets. Cerullo also told Jett that Kidder was starting negotiations with foreign banks for a large loan, so Jett would have to reduce assets for an extended period, sources say. Reducing assets would increase Kidder's return on assets, which was a key barometer of financial health to the banks.

In January, though, Jett could not get his inventory back. Kidder, according to Jett's account, worried that that would cause the balance sheet to increase again during the quarter. Jett, thus, had to keep extending, or not settling, both his forward strip and forward recon positions.

SCAPEGOAT? Then, disaster struck at the end of the first quarter, Jett is saying. Sparked by a big hike in interest rates in early February, Kidder started to have trouble financing its huge mortgage inventory. At the same time, Kidder was hit by losses in the collapse of Askin Capital Management, a customer of Kidder's. The firm was so desperate to shift assets off the balance sheet before the quarter's end, according to Jett's story, that the back office staff had to come in to Kidder's offices over the weekend. The staff, though, was unable to enter trades that were done in the first quarter in the second quarter, which, Jett is saying, put Kidder in violation of the Security & Exchange Commission's net capital rules. Both Kidder and the SEC deny Kidder was in violation.

Jett is saying that the firm decided to pin the huge losses suffered by the highly visible mortgage department on him. Thus, he was forced to liquidate many of his forward recon positions, which created $100 million in losses.

There is plenty of room for skepticism of Jett's account. Four accounting experts interviewed by BUSINESS WEEK say they doubt important aspects of Jett's account. If Jett's version was accurate, they say, Kidder would be guilty of using questionable, and, in some cases, inappropriate accounting procedures. Jett's defense "sounds like total double talk," says Donald J. Kirk, an accounting professor at Columbia University's business school.

Specifically, the experts doubt Jett's assertion that Kidder's accounting system could have allowed such a huge discrepancy between how bonds and strips are accounted for. They say it is highly improper, in accounting for strips, to include on the balance sheet the entire future stream of interest payment. "It's total baloney," says the chief accountant of a Wall Street firm.

For all its possible defects, Jett's story is certainly intriguing. The big issue now is whether the Feds will buy it.Leah Nathans Spiro, with Linda Himelstein in New York and Michael Schroeder in Washington


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