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									                Kidder, Peabody & Co

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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