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Rogue Trader Broadsides Kaufman and Broad
By Brian Graney (TMF Panic) August 31, 1999

Investors got a quick reminder of one of the many risks inherent in equity investing this morning when Los Angeles-based homebuilder Kaufman and Broad Home Corp. (NYSE: KBH) warned that its third quarter earnings would fall $0.24 per share below previous estimates. Here's a quick multiple choice quiz for investors:

Is the reason for the shortfall...

A. Lower than expected sales growth?
B. Falling margins?
C. A poor product mix?
D. An employee gone haywire?

In this case, the answer is D. In a statement this morning, Kaufman and Broad said that it has discovered that an employee in its wholly owned mortgage banking subsidiary has been making "unauthorized" mortgage loan trades. That's trading language for bets that were really, really bad. Like other mortgage bankers, the unit sells loans into the market that roughly match the loan commitments made to Kaufman and Broad homebuyers. This works as a hedge, covering the unit's exposure to interest rate fluctuations between the time the loan commitments are made and the time those same commitments hit the secondary mortgage market.

Apparently, the rogue trader was not quite of the same trading caliber as, say, George Soros. As a result, Kaufman and Broad will record a $0.24 per share non-recurring loss in the quarter. Based on the company's diluted sharecount at the end of Q2, that works out to an $11.4 million hit. That's pretty impressive when you factor in that the firm's mortgage banking business only accounted for $14.7 million in revenues last quarter.

Not surprisingly, the employee in question has been asked to hit the road. "We are confident that we have identified and recognized the full extent of the loss and that we have taken appropriate steps to prevent future unauthorized trading activities,' CFO Michael Henn said. Meanwhile, Henn reassured investors that the homebuilder's core operations are still running smoothly, with preliminary unit orders showing strong growth in August and for the quarter. That seemed to minimize the damage this morning, and Kaufman and Broad's shares only fell slightly.

The lesson to be drawn from the misfortune is that there is no way for investors to quantify every single risk associated with becoming a partner in a publicly traded company. It's true that management should be held accountable to maintain sufficient internal control levels and to know as much as it possibly can about everyday goings-on inside the company. But at the same time, it's impossible for a company like Kaufman and Broad, which has 3,200 employees worldwide, to protect itself against every worker that may develop a Nick Leeson complex at some point down the road. (Leeson, you'll remember, is the rogue futures trader who single-handedly brought the British investment house Barings to its knees in 1995.)

Rather than trying to quantify wacky employee risk, investors should try to minimize investment risk by learning as much as possible about the companies they are investing in. This includes but is not limited to understanding the company's business model, its competitive position within its industry, and the future expectations represented by its valuation in the market. Risk is part of the deal when it comes to investing in stocks. However, its existence alone should never deter anyone from forgoing the well-documented benefits of long-term equity investing.

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