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Joseph Jett: A Scoundrel or a Scapegoat?

April 6, 1997

By SAUL HANSELL -- New York Times

There is an oversized desk calendar, used by many of his fellow employees, detailing transactions that are now described as fraudulent. And there is a taped telephone call in which a boss proposed to "window dress" the company's balance sheet. And there is an auditors' report that raised no alarm.

In a case that has produced a mountain of evidence, these are only fragments. Still, they are enough to give hope to Joseph Jett, a pariah on Wall Street.

Month after month, the former superstar bond trader at Kidder, Peabody & Co. has tediously sorted through 429 boxes of documents, computer records and tapes, trying to refute accusations that he engineered an astounding $339 million in phony profits.

Between odd jobs on construction sites and making deliveries -- and occasionally investing on others' behalf -- Jett has acted as his own paralegal, rummaging for anything that might clear his name.

Now Jett's melancholy but tenacious three-year struggle is nearing an end. With an administrative law judge's ruling expected in the next few months, Jett will be certified as either one of Wall Street's great scoundrels or one of its most vilified scapegoats.

As he awaits the ruling -- on a Securities and Exchange Commission complaint against him -- Jett and his lawyers offer up the scribblings of his former colleagues as confirmation that Kidder officials knew all about his trading strategies. And in some finger-pointing of their own, he and his lawyers cite cryptic recorded conversations as evidence that top officials urged him to help deceive General Electric, Kidder's parent at the time.

Considering the intensity of his public shaming when he was dismissed in April 1994, Jett has been able to mount a remarkably vigorous defense. Just before Christmas, a securities arbitration panel awarded him $1 million of his Kidder bonuses after ruling that the firm was unable to prove he engaged in "fraud, breach of duty and unjust enrichment."

The arbitration hearing and a trial last summer on the SEC accusations have produced a mass of intriguing documents and sworn testimony, while subsequent interviews have filled in some gaps. At the least, the evidence adds up to an extraordinary chronicle of negligence by Kidder officials who were supposed to supervise Jett but missed one opportunity after another to halt his trading.

Instead, they happily allowed his trading and generously rewarded it. Dozens of people were aware of a central component of his strategy, but no one, either out of ignorance or worse, objected to it as being based on an outright fiction.

Some former colleagues of Jett suspect that the firm turned a blind eye because of an eagerness to breed star traders, and to impress GE, which in 1994 finally sold the firm out of disgust.

After an internal investigation, a humiliated Kidder and GE acknowledged intolerable lapses of supervision. But whether Kidder officials countenanced Jett's activities, explicitly or tacitly, remains an issue -- one that may only be settled when a judge decides whether to fine him $20 million and expel him for life from the securities industry, as the SEC has requested.

Until then, questions persist: Can Jett be guilty of fraud if he hid nothing, falsified no records and was subject to several levels of oversight? Did Jett know full well that his trades were nothing more than make-believe? Or did he naively believe that the profits his computer reported had to be real? "They accuse me of fraud, but there is so much evidence that I was open and honest and that other people looked at and understood my positions," said Jett, who contends he was singled out for blame to insulate GE from shareholder lawsuits.

Kidder and the SEC say Jett, through manipulative trading practices and by lying to management, concealed a computer accounting glitch that allowed him to report unearned profits. So illogical was Jett's trading, the SEC maintains, that there is "no conceivable explanation other than fraud."

Yet some former Kidder employees furnish another explanation -- that a relatively inexperienced Jett, now 39, truly believed the profit figures that flashed on his computer terminal.

Superman Trader: A Sputtering Career Finds a Vehicle

"I think Joe was someone who had a tremendous psychological need to be a star trader," said a former top Kidder executive who spoke on condition of anonymity. "It was like a lab rat in a cage. He pushed the lever, and food came out. The rat doesn't give much thought to why the food came out."

When Jett arrived at Kidder in 1991, he badly needed to succeed. He had already been laid off from one Wall Street firm and dismissed from another, after abandoning a first career in chemical engineering.

Not the best start for someone with an MBA from Harvard and an engineering degree from MIT. Now he needed to draw on a reservoir of self-reliance and discipline. His father, one of the first blacks to command white troops in the Korean War as an Army sergeant, had drilled those qualities into him when he was growing up in Wickliffe, Ohio, outside Cleveland.

Despite his previous missteps on Wall Street, Jett was an attractive prospect for Kidder. As an engineer, he would be adept at quantitative trading techniques, and GE was pressing Kidder managers to bring more members of minorities into senior positions.

Jett, who described himself as opposed to racial preferences just as his father had been, said the trading desk was the meritocracy he desired. Traders' profits and losses are tallied daily, and they are the only score that counts.

Jett's new boss, Edward Cerullo, had a reputation for being steely and ambitious. Fortunately for Jett, his boss took risks, both with money and with people. He had nurtured some outstanding young traders, making the fixed-income department a powerhouse that accounted for nearly all of Kidder's profits.

GE liked the money Cerullo's department was earning, but worried that it was too dependent on the volatile mortgage bond market. Kidder needed to develop other lines of business.

To Cerullo, former colleagues say, an instinctive solution was to find the next hot talent. "Ed was absolutely a believer in Superman traders," a former trader at Kidder said. "Just because no one else could make money in a certain market doesn't mean that a Superman couldn't."

At first, Cerullo assigned Jett to the sleepy zero-coupon bond desk, under the wing of Melvin Mullin, a former college math teacher and the chief of Kidder's government bond business. He taught Jett how to scan the market to buy bonds cheap and sell them dear, using a Mullin-designed computer system known as the Government Trader. One trick was to sometimes squeeze profits from the minor price differences between zero-coupon bonds and regular government bonds.

This is possible because of the way the Federal Reserve creates zero-coupon bonds. It takes a regular 30-year bond, which pays interest every six months, and "strips" it into as many as 61 separate securities, or zeros. One zero-coupon bond corresponds to the final principal payment, and up to 60 zeros correspond to each semiannual interest payment; investors are entitled to a single payment at maturity.

If demand is higher for zeros than for regular government bonds, a trader can buy a bond, then have the Fed strip it and sell the pieces for more. If demand for zeros is lower, the trader can buy all the pieces and "reconstitute" them at the Fed into the original bond.

Mullin's computer system was constantly searching for money-making possibilities in stripping or reconstituting bonds.

During Jett's first five months on the job, he made only $417,000 for the firm, far less than the relatively modest goal of $1 million a month that Mullin had set for him. In October 1991, Kidder gave Jett his first bonus -- a paltry $5,000. The message was unmistakable: shape up or get out.

In short order, Jett's profits started to escalate. In the first 10 months of 1992, he reported trading profits of $28 million. Jett was awarded a bonus of $2 million.

At the time, Mullin now explains, Jett's turnaround seemed to make sense. Jett was a hard worker, he said, who often arrived at the office earlier and stayed later than his co-workers.

Slowpoke Technology: A Program Glitch, a Profit Mirage

As Kidder now calculates it, $17 million of Jett's $28 million in apparent profit was not from legitimate trades but solely from a glitch in the way its computer system processed the stripping and reconstituting of bonds.

With the flickering, touch-sensitive computer screens, Mullin's Government Trader system appeared to be at the vanguard of Wall Street's high-technology revolution. In reality, it was a silicon veneer over a patchwork of archaic computer systems based on software written before Neil Armstrong walked on the moon in 1969.

The computer systems didn't take well to Wall Street's new, more complex inventions, and that goes a long way toward explaining how the accounting on Jett's trades went awry. Although Kidder had long been working on a new system, it never finished the job.

The process of stripping and reconstituting zeros was relatively simple by contemporary Wall Street standards. But Kidder's system was incapable of making dozens of zero-coupon bonds disappear in a reconstitution and then making a conventional bond materialize in their place, or vice versa.

So Kidder's programmers treated any exchange of zeros for conventional bonds as a sale and a purchase. Although no cash ever changed hands, the shortcut required entering an equivalent "price" for each side of the trade.

This artifice might have remained forever unnoticed, and harmless, if it hadn't been for a seemingly minor mistake: Mullin allowed strips and reconstitutions to be settled up to five days in the future.

Such forward trades are normal procedure in much of the government bond market, including zero-coupon bonds. But forwards don't exist for reconstitutions. After all, reconstitutions aren't really trades; they are more like the exchange of four quarters for a dollar. Why arrange in advance to do that?

Mullin said he did not know all that at the time. Even so, he still contends, scheduling reconstitutions in advance, as Kidder did, gave the firm's back office time to assemble the strips it needed to carry out the transaction.

The method of accounting for profits was another matter. On Wall Street, forward trades are firm commitments, so investment firms start keeping track of profits or losses on them right away.

With its makeshift system, Kidder was doing just that with Jett's reconstitutions, recording profits on the day he entered them that would vanish by the time the trade was settled.

The heart of the problem is that conventional bonds stay even in price as long as interest rates are stable, while zeros go up every day, with daily interest earnings built into the price.

The moment Jett entered into a reconstitution that would be settled several days in the future, the computer would immediately calculate the transaction as being profitable. That was an error, and it came about because the strips could be bought in the open market on that day for less than they were scheduled to be sold for when the transaction settled -- after interest had a chance to accrue.

In a reconstitution scheduled to be settled in five days, for example, the difference between the two prices was equal to five days of interest. That profit, however, was ephemeral. The next day, the computer would record a profit from the very same transaction equal to only four days of interest. By the time the transaction settled, the supposed profit would disappear, as if it had never existed.

But Jett kept entering into more reconstitutions. As a result, the firm credited him with ever increasing profits.

In October 1992, the Government Trader system was upgraded with a new generation of software and a more powerful computer. One improvement was the ability to arrange trades that would be settled well beyond the five-day limit, allowing them to be concluded months into the future.

Kidder said Jett had requested the change to further his fraud; he said others asked for the change, too. In any case, it proved to be a bonanza. He set the settlement dates for his reconstitutions even farther into the future; the farther off, the greater the profit the firm recorded on his behalf when the transaction was first arranged.

On Nov. 17, 1992, Jett tapped on the screen to reconstitute $200 million of bonds 203 days ahead -- on June 8, 1993. That produced an immediate profit of $12 million. Jett said that was the first time he noticed the big profits to be had from forward reconstitutions, and he sought an explanation from Moshe Benetar, a programmer who helped design the Government Trader system. By Benetar's own account in an interview, he responded that the system was supposed to work that way.

Throughout 1993, Jett entered an escalating series of forward reconstitutions. These trades were used, the SEC said, to generate "more false profits when his real trading lost money."

From March 1993 through the end of the year, Jett earned no less than $10 million a month for the company. And when Mullin moved on to another assignment, Jett took his place supervising all government bond trading. By the end of 1993, Jett was made a managing director of Kidder, Peabody, named its "man of the year" and awarded $9 million in bonuses on $150 million in reported trading profits.

Half-Hearted Inquiries: Easy Answers, Easy Acceptance

On Kidder's trading floor, there was more than a little curiosity about how Jett seemed to mint money. Traders who could track his trading with customers -- as opposed to his reconstitutions with the Fed -- figured that his business couldn't be all that profitable.

In an interview, Mullin said that long after he had switched jobs and Jett was no longer his responsibility, he nonetheless casually asked Barry Finer, the risk manager in the fixed-income division, how Jett was making money.

"Barry said he has a big bet on the shape of the yield curve" -- the gap between short-term and long-term interest rates, Mullin said.

"I said we don't do that," Mullin recalled. "And Barry said, 'Jett can do anything he wants.' " Finer declined to comment.

Among those raising concerns were some people on the repurchase desk, which was responsible for helping Jett assemble all the zero-coupon bonds he needed to carry out reconstitutions, often borrowing them from other firms. But the repurchase desk could hardly keep up with the pace set by Jett. Handicapped by Kidder's ancient computers, it resorted to using a heavy red appointment calendar to keep track.

Jett now cites the appointment book as evidence that he did not hide his trading strategy. Notations were made for thousands of strips and reconstitution trades to be settled weeks and months into the future, even though, as much of Wall Street knew, the Fed didn't engage in such forward trades.

By at least one Kidder executive's account, as many as 100 people referred to the appointment book or were otherwise involved in the forward reconstitutions.

James Rizzi, a trader on the repurchase desk who was in charge of strips, raised an alarm in 1993 with David Bernstein, an accountant who functioned as chief of staff to Cerullo. But Rizzi said he was waved off.

"Since we were not settling any money, my concern was that they were paper trades," Rizzi testified at the SEC's fraud trial. Bernstein, according to Rizzi's testimony, responded that "he was sure these were not just paper transactions."

Rizzi's concerns were not allayed. So his boss, Brian Finkelstein, later took up the issue with Bernstein, raising the possibility that the recorded profits were "an illusion," Finkelstein testified. When Bernstein again said the profits were real, Finkelstein suggested that Cerullo should be brought into the discussion. "Ed already knows," Bernstein replied, according to Finkelstein's testimony.

Bernstein recalled the conversation differently, contending that he said he knew of nothing wrong with Jett's trading and that he suggested to Finkelstein that he speak with Cerullo.

As for Cerullo, he testified to knowing that Jett was active in reconstitutions and that Jett was engaging in forward trades. What he didn't know early on, he said, was that Jett was doing reconstitutions on a forward basis.

Cerullo also said he, too, periodically made queries about Jett's trading, but not because he worried about fraud. Any rapid increase in profits, Cerullo testified, was a warning of too much risk-taking. At one point, Cerullo dispatched Finer, the risk manager, to check into one area of possible risk -- whether Jett was betting too heavily on interest rates.

According to Finer's testimony, Jett told him the profits were from three roughly equal sources: trading with customers, stripping and reconstituting bonds, and trading to exploit discrepancies between the prices of bonds and bond futures. Finer never verified the numbers.

"It wasn't my position to be satisfied or not" with Jett's answers, Finer testified. "I was asked to pose the questions. I posed the questions."

Jett cites another exchange as tacit authorization for his trading approach and the way profits were being credited to him.

In May 1993, he had a series of short meetings on the trading floor with Bernstein and Charles Fiumefreddo, a top accountant in the fixed-income division. The accountants, taking notice of Jett's forward trades, needed Jett's help in identifying them because such trades were supposed to be excluded from the firm's balance sheet.

When asked, Jett said most of his forward trades were reconstitutions with the Fed. Although Bernstein said he was unaware that such transactions were a fiction, he did ask what would turn out to be the right question: Did Jett get credit for a profit he hadn't earned the moment he entered a forward reconstitution? Other types of forward trades had resulted in such accounting distortions in the past, so Bernstein thought Jett's trades might pose the same problem.

Jett said he acknowledged an unearned profit on forward reconstitutions but argued that it was nothing more than advance credit for earnings on other transactions that were part of his broader strategy.

Bernstein's account is different. He recalls that Jett said a reconstitution did not automatically create a profit.

Yet shortly after Jett was dismissed, Bernstein's comments were more in line with Jett's version. According to notes taken by lawyers hired by Kidder to investigate the scandal, Bernstein said of the profits, "We didn't view it as false, just accelerated." Bernstein says the quotation was taken out of context.

As Jett describes it, the accounting executives ultimately fussed only about the need to account for the cost of financing the transactions. Still, no change was made in how profits were tallied because Kidder's accounting system couldn't accommodate one.

After spending 400 hours reviewing Jett's zero-coupon desk in August and September 1993, Kidder's internal auditors did not do any better at detecting problems. They unquestioningly recorded that much of Jett's trading was in reconstitutions and that 20 percent to 40 percent of his desk's trading was on a forward basis.

Paper Trades: A Change in Rules, Then an Unraveling

y the autumn of 1993, GE had begun to look with dismay at the size of Kidder's portfolio of bonds. The firm's assets had ballooned to 100 times its capital, and it was borrowing at more than twice the rate of any other firm on Wall Street. Worried about risks, GE ordered Kidder to cut back on its holdings, and it gave the firm three weeks to meet its target.

Jett was told to reduce his combined bond holdings from $22 billion to $16 billion. Because of an accounting change, Jett's forward reconstitution trades now stuck out strikingly.

If Jett had reduced his position in forward reconstitutions, he would have incurred a loss. He instead resorted to a complex series of forward trades that simultaneously preserved his profits and complied with Kidder's new balance-sheet restrictions.

Jett and Kidder are now oddly in agreement that his new approach consisted entirely of paper trades, with the sole purpose of manipulating Kidder's financial statements. "We no longer had a profit motive," Jett said. "The trades became more and more a massive juggling act."

Jett says he was ordered by Kidder to engage in the trading to deceive GE. The SEC contends that Jett desperately sought to keep a fraudulent scheme from being detected by Kidder management. The evidence on the issue is ambiguous.

Jett's lawyers point to tapes of telephone calls in which Bernstein instructed Jett on how to use forward strip trades to "window dress" Kidder's balance sheet. Bernstein and Jett talked about "pairing off" and "rolling forward" strips and reconstitution trades so they never actually settled with the Federal Reserve.

"We do our best not to call attention to, ah, you know, the stuff in the strips book, but just for my security going forward, you know, get the stuff done," Bernstein said in a December telephone call, taped as part of Kidder's routine recording of traders' conversations. A month later, Bernstein told Jett that "there's been such volume on pairing off these forwards that it really is, you've gotten conspicuous."

Bernstein testified that he did not understand why Jett was conducting these trades. He said he just became concerned that the maneuvers did not work perfectly, with the effect that the value of his portfolio periodically shot up by a thoroughly unacceptable $25 billion.

In January 1994 Jett's reported profits doubled, and Cerullo asked Bernstein to investigate whether Jett was taking too much risk. One weekend, reviewing the books while attending his son's diving match, Bernstein discovered $42 billion in forward reconstitutions, far more than the firm could ever expect to settle.

It took a few more weeks before Bernstein determined that the forward reconstitutions -- reflecting the residue of months and months of Jett's trading strategies -- were crediting Jett with a cumulative profit of more than $300 million.

That set off a frantic series of conversations between Kidder managers and Jett. After a series of conflicting explanations, Cerullo testified, Jett acknowledged in April 1994 that in the previous six months his forward reconstitutions resulted in fake profits.

"I became nauseous," Cerullo testified. A few days later, Kidder hired Gary Lynch, a former SEC enforcement chief, to investigate. When Jett did not appear for an interview with Lynch, he was immediately dismissed. Jett said a social engagement kept him from the interview.

Costly Lessons: Unjustly Vilified or Justly Punished?

Jett describes the last three years as "a hellish ordeal" in which he was "lynched on the front page."

GE blamed him for a $350 million charge to earnings. Lynch, in concluding his formal investigation for Kidder, accused Jett of deliberately manipulating Kidder's systems. He was grilled dozens of times by federal prosecutors, though criminal charges have not been filed. The SEC filed its fraud complaint in January 1996.

"I have not been able to work in my chosen field," Jett said. "The hardest part of the last three years was realizing I was alone. The people who were in a position to speak the truth were not going to come forward."

He seethes that Kidder has made severance payments to all of his superiors and covered the legal bills for everyone but him.

Last year, Cerullo settled the SEC charge of failing to supervise Jett; Cerullo paid a $50,000 fine and was suspended from the securities industry for a year. Kidder paid him $9 million in deferred compensation and severance. Mullin settled for $25,000 and suspension for three months. Bernstein, who was never accused of any wrongdoing, was reassigned by Kidder when Jett was dismissed and is now a consultant.

Even when Jett's trading earned him lavish bonuses, his life style did not always reflect it. For a long while, his apartment was furnished only with a bed, a stereo and a weight set. After his dismissal from Kidder, with practically all his savings frozen in a Kidder account, self-denial became a necessity. He lived nomadically, staying with friends.

With the arbitration panel's award of $1 million in bonus money, Jett's situation has improved considerably. He has bought new clothes and a cellular phone. He has rented an apartment in the East Village and intends to start a private investment fund. He is also writing a book and hopes to sell his story to Hollywood.

All of this assumes he has a future in the securities business, a safe assumption in his view. For all he and his lawyers have uncovered about how much others at Kidder knew about his trading, his chief point is that it was not his responsibility to question profits being credited to him by Kidder's computers.

"If I am operating under their system to generate profits, with their approval," Jett asked, "and they turn around and change the rules so the reasons you had for doing this no longer exist -- and, by the way, we are taking all the money back we paid you -- is that fair?"

Lynch, however, argues that exploiting a dysfunctional system can indeed constitute fraud. "It is like receiving a hundred paychecks each week when you should get one," he said. "It's not a defense to say, 'I assumed the company meant to pay me a hundred times.' "

That defense, however, did sway many of the 500 graduate business students at New York University who gathered one evening last fall to hear Jett unabashedly discuss his case. So, was his story an object lesson to a future generation of financiers eager to avoid the same fate?

Not really. William Starbuck, the professor who invited Jett, said "the overwhelming majority" felt that Kidder and GE "had implicitly defined a game by setting up their accounting system."

In the students' view, Starbuck said, "it is the job of employees to play the game, not to decide whether they are good games or bad games."

Source: April 8, 1997

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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