Kidder, Peabody & Co Authors: Philip Larson Citibank – Philip Larson 1) What were the organizational factors that led to problems at Kidder, Peabody & Co.? There were a number of organizational factors that led to problems at Kidder Peabody. First, the CEO Michael Carpenter had no experience in brokerage, some experience in buyout loans and takeovers, but little understanding of securities trading. Second, the CEO had a strained relationship with the head of GECS causing some synergies, potential oversight, etc. to go unrealized. Lower bonuses were creating disgruntled employees. Third, there was no clear group responsible for overseeing trading strategies. Cerullo was busy supervising various desk heads. Bernstein was primarily focused on whether the trading strategies were properly hedged. O’Donnel created reports and procedures and was responsible for internal audit. However, it was unclear who in the organization was directly responsible for understanding at a technical level, the trading strategy of the STRIPS team and what impact it was having on the firm’s financial statements. Fourth, the organization relied too heavily on its government trading system. This system had problems with its valuation of STRIPS and bonds and no one within the organization appeared to be well-enough informed about the system to insure that it was working correctly. This extreme reliance on the technology helped lead to the problems. 2) Try to understand the accounting for strips and recons. Construct accounting entries to illustrate how to account for a $1,000,000 recon to be settled on the transaction date. What is the effect of this transaction on the balance sheet and income statement? A $1,000,000 reconstitution (“recon”) consisted of purchasing STRIPS and selling an interest-bearing bond. Essentially, a reconstitution should be like “going to the bank with a dollar and receiving four quarters in return” suggesting that it should not have an impact on the overall income statement. That is, no revenues and no costs are incurred in this transaction. However, there is an effect on the balance sheet of this transaction on the transaction date. In particular, for a recon there will be a change in the inventories of strips and bonds. For a recon, in which strips are converted into a bond, the inventory of STRIPS would go down $1M on the transaction date and the inventory of bonds would go up $1M on the transaction date. 3) Similarly, construct accounting entries to illustrate how to account for a $1,000,000 recon to be settled one month in the future. Assume a discount rate (say 1% per month). What is the effect of this transaction on the balance sheet and income statement? Essentially, the Government Trading System at Kidder Peabody would value the STRIPS at their discounted cash flow value (market price) at the transaction date while the bonds were valued at their settlement date value. Therefore, at the transaction date, the System recognized a profit for a recon or a loss for a strip. For a $1,000,000 recon scheduled for a month in the future, the discounted value of the future bond is $1M/1.01 or $990,099.01 market value of the STRIPS. Meanwhile, the system would register $1M in the bonds based on the value of the bonds at settlement date. This transaction had no effect on the P&L statement because the System correctly assigned the same value to the bond and its STRIPS at settlement date. However, the effect on the balance sheet was that at the transaction date, the balance sheet for a recon of $1M for 1 month in the future would register a decrease in STRIPS of $990,099.01 and an increase in bond inventory of $1,000,000. This difference of $9,901 appeared on the balance sheet. However, these “profits” disappeared over time as the STRIPS continued to be marked-to=market at the end of each trading day. 4) How would you assess the risk exposure for Kidder Peabody? Based on your analysis, should senior managers have been able to anticipate the problems described in the case? Based on my analysis, Kidder Peabody was not assuming significant risk in Joseph Jett’s trading positions, per se. He was simply purchasing STRIPS and selling bonds or purchasing bonds and Citibank – Philip Larson selling STRIPS. Kidder Peabody was exposed to interest rate risk because by committing to recons and strips ahead of time, whether they made any real profit on the transaction required either an arbitrage opportunity (if STRIPS were somehow trading below their appropriate value) or if interest rates changed in a way that made their inventory positions in STRIPS and Bonds more or less favorable. The primary nature of Kidder Peabody’s risk was therefore interest rate risk. Senior managers should have been able to anticipate the problems described in the case. Mullin relied to heavily on the computer-generated reports of the GTS without properly reviewing information on settlement dates that might have guided him to understanding the implications of Jett’s trading strategy. When Jett’s profits grew almost five-fold in 1993, Cerrulo should have gone beyond the daily P&L repors, risk reports and other reports to understand why these “profits” were not generating any cash. Moreover, Mullin, before being promoted, was viewing the daily reports on the trading activity of all government desk traders. These reports, and Jett’s major contribution to the divisions’ “profitability”, should have caused Mullin to do a more thorough review of Jett’s trading strategy. The statement that Jett’s “profits have come from intelligent trading activity and close attention to detail” was not based on a thorough analysis of Jett’s trading strategy. 5) Why wasn't the nature of these profits understood earlier? Who was to blame? The primary culprits to blame for failing to understand the nature of these profits were Jett’s managers and the internal audit team. Kidder’s internal audit department reviewed Jett’s transactions on multiple occasions. Neither of these audits uncovered the true nature of the unrealizable profits. The audit team consisted of “inexperienced auditors who relied on Jett’s account of his trading strategy without verifying his statements.” A properly experienced audit team performing their duties well should have uncovered the nature of these unrealizable profits. Jett is also to blame. It is likely that he understood the true nature of his trading strategy and was exploiting a flaw in the GTS system. Rather than exploiting this flaw for personal gain at the expense of his firm and its clients, Jett should have informed his management team of the flaw. While it is not entirely clear that Jett was aware of the nature of the unrealizable profits, it is hard to believe that he could not know. It was worth millions of dollars in salary and bonuses for him to understand why his trading strategy was working so well in relation to others. Moreover, he was probably fully aware of the letter of the law (requiring “intent to deceive”) and therefore made a point to be very open with his management and audit teams. The management team at Kidder was also to blame. Mullin and Cerrulo both had the opportunity and, arguably, the duty to investigate Jett’s trading strategy and understand the nature of his “profits”. Failing to properly manage the members of their team helped lead to the firms’ problems.
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