Will Another Shoe Drop At Kidder?

Even several weeks after the event, Wall Streeters are still trying to fathom it: How was Joseph Jett, an obscure government-bond trader at Kidder, Peabody & Co., able to rack up $350 million in phony profits over a three-year period before the firm found out about it?

Now, Street speculation is shifting to another part of Kidder: its huge mortgage-backed securities business. The question is whether Kidder sustained large losses during the recent abrupt collapse in bond prices, which battered the mortgage-backed portfolios of many other Street firms. Kidder is so big in this market, says Herman Sandler, principal at Sandler O'Neill & Partners, "because they are willing to assume bigger risks. Other people aren't prepared to take that high a risk profile."

"ALWAYS CHECKING." A senior Kidder executive denies this speculation. "We haven't had any big hits because we operate on a hedged basis for the most part," he says. The executive adds that this assessment is based on an outside firm's complete pricing review of Kidder's fixed-income portfolio for Kidder, Kidder's parent General Electric Co., and government regulators. "We are highly confident," the executive says, "that the [prices] are accurate."

While Kidder is only a minor player in government securities, it is thought to have the largest mortgage-backed portfolio on Wall Street. From January to early May, 1994, Kidder issued $28 billion in mortgage-backed securities, for a commanding 24% market share (table). While Kidder won't say how much of its end-of-1993 $72 billion balance sheet consisted of mortgage-backed paper, rivals say it is a significant portion. Much of Kidder's $439 million in 1993 operating earnings is thought to have come from its mortgage business.

Kidder's success is due in large part to 32-year-old Michael W. Vranos, head of the firm's mortgage-backed department. Vranos, who is rumored to have drawn a bonus north of $10 million last year, is widely respected throughout the close-knit mortgage-backed industry.

A source close to General Electric, though, tells BUSINESS WEEK that in the past there has been great concern at Kidder about the firm's huge exposure in mortgage-backed securities. "That was being watched by everybody inside and out," says this former GE insider. Kidder Chief Executive Michael A. Carpenter "was always checking."

In trying to judge the riskiness of Kidder's mortgage-backed portfolio, a key issue is how much of it consists of high-risk mortgage derivatives, such as inverse floaters and interest-only securities, whose value can fluctuate radically with a big move in interest rates. Several customers of Kidder's, such as Askin Capital Management and Piper Jaffray Inc., have been badly whipsawed by the impact of rising rates on the value of their mortgage derivatives. Since Kidder is thought to be such a big owner of these securities, the rate rise is believed to have sparked losses of its own.

JUMPING SHIP. Fueling speculation is the recent departure of Kidder's No.2 mortgage pro, Mitchell Samberg, who left to co-head Donaldson, Lufkin & Jenrette Securities Corp.'s collateralized mortgage-obligation department. Another departure was Dmitry Shklyar, who just joined CS First Boston as a mortgage-backed-derivatives trader. These losses are "a bearish sign," says one competitor, because for the past five years, competing firms have had little luck luring away Kidder mortgage traders. Samberg and Shklyar declined comment.

Despite Kidder's statement that it did not take any major hits and that its bond portfolio is accurately priced, mortgage-backed traders remain skeptical. The big interest-rate hike has made it very difficult to estimate prices for CMOs and CMO derivatives, which are often very illiquid. Kidder's mortgage-backed portfolio is thought to be worth from $10 billion to $15 billion, and Street sources speculate that if it reflected current values, losses could be several hundred million dollars.

Any portfolio losses would be in addition to the $210 million write-off stemming from the Jett trades. Kidder's financial viability, though, won't be impaired. GE, says Perrin H. Long Jr., research director at First of Michigan Corp., will stand behind the firm. It might, he adds, "have to pump money in." While the precise cost, if any, to bail Kidder out may never be disclosed, GE's investment in Wall Street could turn out to be quite expensive.

                            1993   1994 year to date*
      Manager              Billions Billions
      Kidder Peabody       $81.02   $28.16
      Lehman Bros.          39.93    11.85
      Bear Stearns          37.80    11.65
      *period ending 5/9/94  DATA: SECURITIES DATA CO.