In 1991, Kidder hired Joseph Jett to arbitrage treasury bonds and STRIPS (separate trading of registered interest and principal of securities, i.e., bonds stripped of their coupon payments).
Such arbitrage is theoretically a riskless transaction and would thus not need to be tracked by Kidder
's standard market and credit risk management systems.
The firm relied on a computerized expert system that allowed traders to model and simulate their trades in accordance with software rules about valuing such transactions in the bond market.
The software also automatically updated the firm's inventory, position, and profit-and-loss (P&L) statement.
In keeping with market conventions, the system valued the STRIPS lower than their associated bonds.
This difference was reflected in the firm's P&L statement, which was also the basis for assessing trader bonuses.
By entering into forward transaction on the synthetic STRIPS, Jett
was able to defer when the actual losses were recognized on the P&L statement by taking up still larger positions in STRIPS and then digitally reconstituting synthetic STRIPS already in the system.
In 1993 Jett
enjoyed STRIPS profits in excess of $150 million; he
received a $12-million bonus and the chairman's "Man of the Year" award.
By March 1994, when Jett's positions included $47 billion worth of STRIPS and $42 billion worth of reconstituted STRIPS, Kidder
management decided to figure out Jett's secret.
A month later, the firm announced that Jett
had falsely inflated his
profits in excess of $350 million.
was fired and sued for fraud.