Infectious Greed (32 page)

Because STRIPS represented rights to receive just a single payment in the future, they always traded for less than their face value (the amount the holder would receive at maturity). For example, a STRIPS representing the right to receive $1 million in 30 years might be worth $200,000 today. A STRIPS with a maturity of three years might be worth $800,000 today.

Traders of STRIPS were very active, and the business was extremely competitive. In theory, a trader could buy a bunch of cheap STRIPS, reconstitute them, and then sell the new Treasury bond at a profit. (Or buy the bond, split it up, and sell the STRIPS at a profit.) In reality, such “arbitrage” opportunities were rare. These trades were easy to do and their costs were low. The Chicago economists who had predicted efficient markets could cite STRIPS as Exhibit A. There were no $20 bills lying around the STRIPS market.

Jett was assigned to trade STRIPS of ten years or longer.
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He had no training in STRIPS (he had been in mortgages at First Boston), and Mullin expected him to learn on the job. During the first few months, Jett's results were discouraging, and Mullin was concerned. Then, on September 20, 1991, Jett had his eureka moment.

Jett knew that STRIPS traded at a discount to their face value. In the above example, the 30-year STRIPS were worth $200,000; the 3-year STRIPS were worth $800,000. Over time, the value of STRIPS approached their face value. In other words, the day before maturity, the $1 million face value of STRIPS might be worth $999,900. This made sense: a person would pay a lot more to receive $1 million tomorrow than to receive it 30 years from now. STRIPS increased in value over time, just as money in the bank did.

On September 20, Jett noticed that Kidder's accounting system allowed him to record a STRIPS transaction in which the purchase and sale of bonds would occur, not right away, but instead at some future date. In other words, rather than buying STRIPS today, reconstituting them, and selling the resulting bond today, Jett could agree today to do the same transaction six months in the future.

Why would he agree to do the reconstitution in the future, instead of today? This was the eureka. When Jett entered a future trade—a
forward reconstitution
—into Kidder's accounting system, it produced an automatic profit. Why? Recall that a reconstitution involved a sale of
STRIPS and a purchase of the corresponding bond. To make a profit, Jett needed to be able to buy cheap STRIPS. Kidder's accounting system guaranteed that Jett could always buy cheap STRIPS, because it was misprogrammed to record the fact that STRIPS became more valuable over time, and to give the trader credit for that increase—not in the future—but
today.

In other words, Jett could buy STRIPS today for, say, $200,000, and agree to sell them in six months as part of a forward reconstitution. Kidder's accounting system would record the sale price of the STRIPS as if time had moved forward by six months, when the STRIPS would be worth, say, $250,000. In this example, the system would record $50,000 as profit—the difference between the “forward price” and the current price.

In reality, there was no profit at all. If Jett bought STRIPS today and committed today to sell them in six months, he would make nothing at all today. The value—in today's terms—of the STRIPS he had bought was exactly equal to the value—again, in today's terms—of the STRIPS he had agreed to sell in the future. Jett
might
make money over time, if he held on to those positions, depending on changes in interest rates. He might lose money, too. But he clearly would
not
make money up front. The accounting system was comparing forward values to today's values, something that was as mathematically false as subtracting four from four and getting one.

Jett did a few forward reconstitutions, and Kidder's accounting system magically showed that he had made a profit. Suddenly, after four months of poor performance, Jett was making money. For November and December 1991, his forward reconstitutions showed a $265,000 gain. Not bad.

Melvin Mullin was pleased with Jett's turnaround. Another STRIPS trader complained to Mullin about Jett's trading practices, and accused Jett of mismarking his positions. But Mullin brushed off these complaints. After all, the accounting system showed a profit. (Notwithstanding his mathematics Ph.D., Mullin later would claim he hadn't understood Jett's transactions.) A few months later, Jett ensured that the complaining trader would be fired, by delivering to Edward Cerullo a tape of a conversation in which the trader sought employment at another bank. Ironically, this trader ended up at First Boston, where he became a successful STRIPS trader in a group that made millions of dollars trading with Jett.

Nevertheless, Mullin was cautious about Jett. In a year-end performance evaluation, Mullin gave Jett the next-to-lowest mark for “Overall
Rating,” but the highest mark for “Performance Trend.” Mullin wrote that Jett had had a “lower start than anticipated” but “seemed to be improving.” The improvement wasn't enough to justify any big money, though. Jett received a token bonus of $5,000.

In 1992, Jett finally began to impress Mullin, and he began trading in forward reconstitutions at a frenetic pace. At the end of the year, Kidder's accounting system recorded profits of $32 million for Jett, well above what anyone at Kidder had ever made trading STRIPS. Mullin was ecstatic, and recommended that Jett be promoted to senior vice president. In reality, Jett had lost $10 million. His profits were false, although apparently no one at Kidder knew it. Jett received a bonus of $2.1 million. He was a new man.

A few months later, Edward Cerullo—the head of bond trading—told Mullin he wanted Mullin to run a new derivatives desk. Other banks—including Bankers Trust, First Boston, and Salomon Brothers—were making a fortune in derivatives, and Kidder wanted to be involved, too. The only question was who should replace Mullin? The two men decided on Jett, and in 1993—after less than two years at the firm—Jett became head of government-bond trading, supervising about twenty traders. Jett began reporting directly to Cerullo.

Again, Jett didn't disappoint, at least on paper. In 1993, he showed trading profits of nearly $151 million—more than a quarter of the profits in Kidder's entire bond-trading operation. In reality, he had lost almost $100 million dollars, but Cerullo didn't know it. Cerullo decided to pay Jett a record bonus of $9.3 million—more than triple what Andy Krieger had earned at Bankers Trust a few years earlier. If any managers at Kidder questioned how Jett, previously a total flop, had become the firm's wunderkind, they didn't voice their concerns. Instead, Jett was a hero and was named Kidder's “Man of the Year.”
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At Kidder's annual retreat, in Boca Raton, Florida, Jett gave an intense motivational speech, which Kidder's general counsel described as “an emotional let's-go-out-and-win kind of thing.”
¹¹³

When Jett began 1994, he was out of control. In the first two months of 1994—even as fund managers including Robert Citron, Worth Bruntjen, and David Askin were imploding—Jett set another record: $66 million of profits. Finally, his bosses began to ask some questions. How was Jett making so much money? When Cerullo looked at Jett's trades and discovered more than $40
billion
of forward reconstitutions—in some
cases, more than the entire amount outstanding of a particular U.S. government bond—he was stunned.

Cerullo's first reaction was that he wanted to be sure those transactions wouldn't appear on the firm's financial statements. Even General Electric wasn't a big-enough company to have one trader with so many assets and liabilities. An extra $40 billion of entries on GE's balance sheet would jeopardize its AAA credit rating, and investors would bail out of the stock. As Kidder looked at ways of avoiding disclosure of these trades, no one focused on the issue of whether the profits were real. Everyone assumed they were real; they just wanted to hide the size of the bets. Jett apparently believed Kidder's senior management supported his trading as a way of “window dressing” the firm's balance sheet.
¹¹⁴
The forward reconstitutions were classified as a type of over-the-counter derivatives transaction, and—remember—those were largely unregulated and did not need to be disclosed. For GE, they were safely “off balance sheet.”

Finally, in late March 1994—just as Worth Bruntjen was struggling to evaluate his inverse IOs and David Askin was receiving margin calls—one of Cerullo's deputies discovered the accounting glitch. Cerullo demanded that Jett explain his trading strategy in writing. The explanations made no sense, and Cerullo's deputies calculated that Jett had lost about $350 million. Now, Cerullo had to tell Jack Welch.

Welch was advised that Kidder had a “reconciliation problem,” but, ten days later, Kidder officials still could not figure out what had happened. The $350 million loss caused GE to report only $1.068 billion in profits for the first quarter of 1994, less than the $1.085 billion in 1993, the first time in fifty-two otherwise-perfect quarters that earnings were less than those of the previous year.
¹¹⁵
At this point, it is possible that even Robert Citron, the Orange County treasurer, heard Jack Welch scream.

Welch could barely contain himself in public, stammering, “This reprehensible scheme . . . has all of us damn mad.” When a
Wall Street Journal
reporter asked Welch to respond to comments that he had lost his management touch, he shot back, “Who says that? Be sure and quote them by name.”
¹¹⁶

Welch immediately hired Gary Lynch, the former Securities and Exchange Commission enforcement lawyer who—in another demonstration of how little the circles of Wall Street extended—had investigated Kidder Peabody's Martin Siegel during the 1980s. When asked whether Kidder
should have tighter controls, Welch—referring to Lynch—snapped, “I'm paying a lot of bright people a lot of money to find out.”
¹¹⁷

After firing Jett on April 17, Cerullo left Kidder in July with a $10 million severance package, only $50,000 of which he paid to the SEC to settle the case against him (he didn't admit liability and was barred from the industry for one year).
¹¹⁸
Mullin resigned the next month, and Kidder suspended several other officials. Welch had no more patience for his tarnished bond-trading firm—which no longer was the number one or two business in its area. He quickly sold Kidder to PaineWebber, which kept some of Kidder's employees and assets, but deleted the firm's name.
¹¹⁹
Twenty-five hundred employees were offered a harsh severance package that included just two weeks' pay for each year of employment, and that required them to agree not to publish any books related to their experience.
¹²⁰

Lynch's report criticized Kidder's lax oversight, and described a culture in which employees were unwilling to ask questions about a successful rising star. It focused the blame on Jett, and didn't criticize Jack Welch or General Electric. Several senior partners from Lynch's law firm had spent months working on the report, billing huge numbers of hours. For GE, it was worth every penny.

Welch later admitted that he and his managers hadn't really understood Kidder's business. In one interview, he described getting into a business they didn't understand, and stressed the importance of culture: “Culture counts. When I got into one I didn't understand, we screwed it up. We were lucky it was small enough. We sold it and got out. And got out alive. But it could have eaten us up if it were a bigger thing.” Not surprisingly, Welch didn't focus on Kidder or Jett in his 2001 autobiography, except to note that when he learned of the losses, he vomited.

Jett remained a mystery. If he had intended to engage in a fraudulent scheme, he had done so very foolishly. Jett had conducted his trades openly on Kidder's accounting system, which many other traders used and numerous employees could access. Jett also had recorded the trades in large “red books,” ledgers he kept on his desk. He even had helped Kidder's auditors with inquiries into his trading (they said Jett “was more helpful than most other managers”).
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Jett also had kept all of his cash bonuses—millions of dollars—in accounts at Kidder, where they were immediately frozen when his bosses discovered the losses. By 1996, Jett was down and out, moving from one friend's apartment to another,
unable even to afford the $500-a-month rent for a tiny studio in Hell's Kitchen, spending most of his time preparing his legal defense.
¹²²

Jett ultimately was acquitted of securities fraud, showing how difficult it was for prosecutors to send any participant in an alleged fraudulent financial scheme to jail. (He was found guilty of the lesser charge of false record keeping and fined $200,000.) Jett also avoided damages from civil lawsuits, which General Electric settled for $19 million. Ironically, the publicity surrounding Jett's failed prosecution enabled him to revive his career. He became the chief investment officer of a multimillion-dollar offshore investment fund, which even advertised Jett's experience at Kidder Peabody managing “roughly 10% of the assets of Kidder's parent, General Electric.” If you are impressed by this, and want to invest your money with Jett, you can do so at
www.josephjett.com
.

 

 

T
he collapse of Kidder Peabody raised troubling new questions. It seemed virtually impossible to design a system of controls that would catch a rogue trader. Although Jett's remarkable turnaround might have generated suspicion in a different industry, it was very common for traders to find a new product or strategy that produced unusually large returns. How could a manager tell if Jett was different from one of John Meriwether's traders at Salomon?