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Lessons From The Kidder-Jett Debacle of 1994

Eric Falkenstein  10/30/03

The main benefit of failures is not schadenfreude, but how they highlight key risk management principals.  God knows that risk management principals need anecdotes, because otherwise it’s just pure logic vs. the largest PNL generator, a mismatch in favor of the latter.

Recap

To recap, the case was this.  In 1991 Kidder, Peabody & Co. hired Joseph Jett to their Strips trading desk.  In his first 6 months the desk did not make money.  Then reported profits grew quickly: $32 million, $151M, and $81M for 1992, 1993 and the first quarter of 1994, respectively.  Jett was Kidder’s ‘man of the year” in 1993 and awarded a $9 million bonus (his boss Ed Cerullo got a $20 million bonus in 1993, primarily for overseeing Jett’s activities).  It was later reported Jett’s desk lost $85 million over that period, a $358 million cumulative write-down.  The false profits were the result of an error in their internal accounting whereby a zero-coupon bond was treated like a coupon bond.   Thus a forward reconstitution, which exchanges a zero for an identical coupon bond, created instant profits.   

Lessons Learned

1. Beware growing balance sheets and trading volume.  Kidder’s balance sheet ballooned as the ponzi scheme required ever larger positions to add to the false profits (volume was $25 billion, $273B, and $1,567B for 1991, 1992, and 1993, and an incredible $1,762B for the first 3 months of 1994!).  Any time notional amount grows dramatically it is wise to double check the business model.
2. Most value-destroying activity is not illegal.  The SEC and the NYSE brought fraud suits against Jett and his two supervisors, Ed Cerullo and Melvin Mullin, but only minimal charges stuck (eg, $50,000 fine against Cerullo, the man who pocketed $20 million in 1993). Kidder and GE shareholders brought suit against Jett for fraud, but as Jett openly engaged in his trading fraud was impossible to prove.  Legal consequences to operational risk are always remote, so do not expect this stick to influence behavior.
3. How one deals with those they disagree with reveals a lot about character and competence.  Joseph Jett writes that when people would ask how he knew what he was asserting, “my answer was always the same: ‘You do understand, don’t you, that I don’t make technical errors?’”  Later, in defense of his trading scheme that was based on a faulty financial model, his excuse was to defer to Kidder’s flawed accounting software  These are both arguments form authority, not reason: in one case deferring to himself (chutzpah!) in the other deferring to a machine.  This kind of inconsistent and illogical reasoning that can take you anywhere.  A manager should be able to sense if workers think this way and keep them from positions of responsibility.
4. Credentials are imperfect signals of competence.  Joseph Jett had an MIT undergraduate degree and a Harvard MBA.  Jett’s boss, Ed Cerullo, was had a respectable career on Wall Street, and was considered street smart and technically savvy.  Melvin Mullin, the one who created the bond software program that Jett abused, had over a decade experience on Wall Street and a PhD in mathematics from NYU.  Their combined credentials are beyond reproach, yet there were all wrong on a basic application of financial math, one central to the erroneous profits the recorded.  Incredibly, even after multiple independent forensic audits, Jett remained adamant that the profits were real, an insistence that is either delusional or incredibly ignorant. An educated fool is a greater fool than an uneducated fool, and there are a surprising number of them.
5. Compensation is an imperfect signal of competence.  It is natural to suppose that the boss with a mansion, summer house, and frequent vacations, has at the very least ‘street smarts’ because obviously he has done something right.  Indeed, successful businessmen are smarter, on average, than your average businessman, but that isn’t to say they are close to beyond reproach.  A large number of millionaire managers have only a superficial understanding of what they are managing.  In the Kidder case everyone’s surprise at the mistaken nature of the reported profits appears genuine, suggesting the situation was more a mix of greed, apathy (‘don’t fix what’s not broken’), and incompetence than calculated deceit.  But how could you justify their multimillion dollar compensation in light of how ignorant they were about the most important part of their job: managing value creation in their sphere of control?  How many managers understand to what degree their net revenue is due to franchise value, carry from a risk factor, or alpha?  I would guess no more than half.
6. The back office and auditors should not be fearful of traders, and it is management’s job to make this so.  In a previous case at Kidder it had been reported that Cerullo had “given latitude in working with the back office to mark their own closing positions.”  Jett admits to swearing at auditors and back office personnel who had the temerity to question him about his accounting or examine his books without his permission.  Obviously, this sort of environment makes audits meaningless.  Just as you don’t let players touch refs, traders should have to treat the back office with respect.  
7. Integrity matters.  Subconsciously at least,  Jett, Cerullo and Mullin should have realized that if you start finding $20 bills all over the floor every day, something is wrong, but that presumes not only intelligence but a conscience: this is probably someone else’s money.  Jett’s behavior was often mean, petty and bizarre, suggesting little empathy and lots of paranoia He would berate subordinates, repeat phrases psychotically (one favorite was ‘disciplined must be maintained!’ to women who said ‘hello’).  His Christmas speech in 1993 embraced the theme of ‘destroying one’s enemies’—a bit harsh for the season—and was generally hated by his colleagues (clue: if everyone dislikes you, you probably aren’t a nice person).  His boss, Ed Cerullo had a pattern of questionable ethics, such as enforcing a trading error that went their way against First Boston (sort of like keeping the money when a waiter mistakenly gives you an extra $20).  Thus it was not surprising that when they found a way to game the system, neither hesitated. 

See links:
http://www.stern.nyu.edu/mgt/private_file/mo/rfreedma_ca/kidder.pdf
http://www.prenhall.com/divisions/bp/app/laudon/exercises/case05.html
http://www.smeal.psu.edu/faculty/huddart/Courses/BA521/Jett
http://harvardbusinessonline.hbsp.harvard.edu/b01/en/common/item_detail.jhtml;jsessionid=EKE0X0XQXCS1WCTEQENSELQ?id=197038 (requires $6.50 fee)
and the book, Black and While on Wall Street.  Joseph Jett and Sabra Chartrand, 1999.  William Morrow publishers.