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The Downfall of Kidder Peabody or Taking ‘the House’ to ‘the Cleaners’

Posted by Larry Doyle on July 28, 2009 12:24 PM |

Some of the greatest financial heists in Wall Street history have been ‘inside jobs.’ What do I mean? Virtually every financial con on Wall Street has been predicated on the ability to control the flow of funds and information from the ‘back office.’

For this very reason, Federal Reserve rules now dictate mandatory two weeks of consecutive vacation for bank employees involved in the markets. Why? During that time period, compliance and control officials can check the books and records and make sure there are no illegal or illicit activities.

I am reminded of this rule in reading a Bloomberg report Kerviel Lawyer Says SocGen Knew of Trading Positions:

Jerome Kerviel, the trader blamed by Societe Generale SA for a 4.9 billion-euro ($7 billion) loss last year, told a French court that his superiors were aware of his activities.

Kerviel never tried to hide his trades and about 300 of the Paris-based bank’s employees would have been able to see his trading positions on his computer, Kerviel’s lawyer Olivier Metzner, said in an interview today. Metzner filed arguments to a Paris court countering prosecutors’ recommendation that Kerviel be tried for abuse of trust, falsifying documents and computer hacking. The filing repeats Kerviel’s long-held stance.

“In 2007, he was making money and they let him go on,” Metzner said. “In 2008, it all went bad, the machine was exposed, they unwound the positions in a panic and they created losses.”

The defense argument is the final step before a decision by investigating Judges Renaud Van Ruymbeke and Francoise Desset in September on whether Kerviel should be tried. The judicial inquiry began less than a week after Societe Generale disclosed the loss on Jan. 24, 2008, after selling Kerviel’s positions.

Societe Generale said Kerviel made trades without proper authorization and hid them with faked hedges.

“The bank wasn’t aware of the extent of Kerviel’s positions,” said Jean Veil, Societe Generale’s lawyer. “That’s been proven by reports by the financial police department, by stock market regulators and by the Banking Commission.”

Whether SocGen management knew of Kerviel’s trading activity or not is for the courts to determine. Either way, though, there was an enormous breakdown in risk management and internal controls.

During my career, the downfall of Kidder Peabody – a 130 year old firm – in 1994 was the greatest example of ‘taking the house’ to ‘the cleaners.’ How did this occur? A government bond trader by the name of Joe Jett figured out a scam to ‘arb his back office,’ meaning he gamed Kidder’s internal systems to create the illusion of hundreds of millions in profits. In the process of doing so, Jett’s trading book in his sector of the market ballooned to astronomical levels.

Could Jett’s fraudulent activity have occurred without the implicit, if not explicit, blessing of his manager? Most people on Wall Street at that time find that hard to believe. Who was Jett’s manager? An individual named Ed Cerrullo, who was fined a token amount and allowed to sail off into the sunset.

I had a limited engagement with Mr. Cerrullo in the late 1980s.  While working at First Boston at the time, I was contacted by a headhunter on behalf of Kidder. I met Mr. Cerrullo. In a short time frame, it became painfully obvious to me that he was strictly trying to plumb me for sensitive information about our business accounting practices at First Boston.

I left my meeting with little regard for Mr. Cerrullo. Six years or so later, I was not surprised to see that one of his traders had taken Kidder’s parent, that being GE and Jack Welch, to the cleaners.


Related Commentary:

The Othello of Kidder Spins His Side of the Story
by Jake Lamar
The New York Observer; April, 1999

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