From The Kidder-Jett Debacle of 1994
A grand financial failure is usually the
combination of several improbable events. Every part of the chain is necessary,
from the protagonist, his managers, the back office, the auditors, and finally
to senior management who must take responsibility for the entire milieu.
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.
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.
- 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.
- 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.
- 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
- 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.
- 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.
- 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.
- 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
(requires $6.50 fee)
and the book, Black and
While on Wall Street. Joseph Jett and Sabra Chartrand, 1999.
William Morrow publishers.