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Kidder Scandal Widens As Disgraced Trader Implicates Management

By Guy HalversonStaff writer of The Christian Science Monitor / July 28, 1994



NEW YORK

CALL it the little scandal that won't go away. Just when it looked as if General Electric Company finally had the trading scandal at its investment subsidiary, Kidder, Peabody & Co., under control, Kidder is back on the business pages.

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Some new allegations, it is felt here, are serious enough to prompt federal regulators to widen the scope of their original inquiry into Kidder.

In June, General Electric brought in a new management team to run Kidder, following allegations that the company's top government bond trader created up to $350 million in bogus profits to mask trading losses of $100 million.

According to the Wall Street Journal, the trader, Joseph Jett, is now telling federal investigators that in early April, two top Kidder officials told him to start liquidating government-backed bonds because of the firm's inability to sell financially hard-pressed mortgage-backed bonds.

Mr. Jett allegedly said that in making such a request, Kidder knowingly violated rules requiring financial houses to maintain a set ratio of net capital to support total assets. Kidder has reportedly denied Jett's charges.

The allegations are only the latest act in the Kidder drama. Last week, Edward Cerullo, Kidder's second-highest executive and Jett's supervisor, stepped down. Other top executives are believed to be seeking work elsewhere.

``Any time you have a firm under public scrutiny like this, morale gets battered,'' says Joan Zimmerman, executive vice president with GZ Stephens Inc., a Wall Street executive recruiting firm.

Ironically, the latest brouhaha about Kidder comes just after the release of an upbeat financial report by General Electric. Last week, GE reported record earnings for the second quarter of 1994. Nine of GE's 12 divisions had earnings gains, including GE Capital Services, the unit that includes Kidder. Earnings for GE Capital were up 12 percent, to $463 million, although Kidder itself posted a loss of $29 million.

Questions now being asked on Wall Street include: Did Kidder officials knowingly violate capital rules? Was Kidder, which has received about $550 million in capital infusions from GE since April, in greater financial difficulty than GE had acknowledged during the spring? How was Jett allegedly able to create such massive bogus trades without detection by Kidder's in-house security team? Where does Kidder, which is the most highly leveraged of the major Wall Street financial houses, go from here?

``Kidder is a sad story for GE, which has manfully been trying to put the matter right,'' says Roy Smith, a professor of finance at New York University. ``Kidder is proof that you can't carry out an aggressive strategy'' in just one financial area without having ``a deep base'' of expertise and success in that sector as well as other sectors, Mr. Smith says.

GE acquired Kidder in 1986. In recent years, Kidder has pursued a strategy of seeking leadership in the somewhat risky mortgage-backed securities sector, Smith says. Profits from leadership in collateralized mortgage obligations (CMOs) would be used to shore up Kidder's other financial services.

Last year, Kidder led all investment houses in mortgage-backed securities, commanding about 20 percent of the market. Rising interest rates have cut into the profitability of CMOs, but Kidder is stuck with a $10 billion portfolio of mortgage-backed bonds.

Kidder's strategy - to seek dominance in one profitable but high-risk financial sector - is similar to the investment strategy at former investment house Drexel Burnham Lambert, Smith says. Drexel dominated the booming junk bond market in the mid-1980s. But following highly publicized insider trading scandals involving junk bonds, Drexel was forced into bankruptcy.

Kidder is different from Drexel in that its parent company has very deep pockets. Still, Smith says, Kidder apparently did not develop the depth of professional staff necessary to sustain such a one-sided strategy.