(FORTUNE Magazine) – As much as General Electric's top executives -- three of whom are pictured at right -- would like to pin the problems at their Kidder Peabody unit on one errant employee, Joseph Jett, and some lax supervision, it simply isn't so. From the details that have so far been revealed in GE's own investigative report, as well as from independent reporting, one glaring fact emerges: The mess at Kidder Peabody -- and it is a mess -- existed long before Joe Jett ever walked through Kidder's doors. For Jack Welch, one of the most widely admired chief executives in American business, the unfolding Kidder story is surely the stuff of bad dreams. It also contains material from which critics, or even jealous admirers of Welch, may be tempted to take some satisfaction. Evidently, some do. During a recent speech at a New York awards ceremony, Welch revealed that his golfing partners had been ruining his putts by asking him, on the green, how Joe Jett was doing. To restore GE's reputation, and perhaps his golf game, Jack Welch has already gone to great lengths, commissioning a speedy internal investigation -- the now famous Lynch report, named for Davis Polk & Wardell lawyer Gary Lynch, who authored it -- and disciplining those the investigation found to be at fault. But the problems at Kidder may have less to do with the fired few than with the business creed to which they subscribed, a creed whose prophet is the charismatic Welch. First, some perspective. For all the talk about the $350 million in phony profits allegedly generated by Jett, Kidder's former chief government bond trader, the financial loss to GE is a pittance. Against the corporate backdrop -- annual earnings of $4 billion, or $2.03 per share -- the $210 million charge that the company took in the first quarter to account for the phony profits works out to a barely visible 12 cents a share. Welch describes the charge as "nothing, a peanut."

BUT THE SIGNIFICANCE of Kidder's problems reaches far beyond GE's income statement. In its entirety, the course leading up to this latest scandal presents a disturbing chronology of bad business decisions and a cavalier disregard for normal operating procedures in pursuit of profits. The Lynch report, though focusing only on one period of time and one department, strikes those themes. It says, "Time and again questions ((about Jett's unusual trading profits)) were answered incorrectly, ignored, or evaded." One important reason for those oversights, the report states, was Jett's importance to Kidder's bottom line. "As his profitability increased," it says, "skepticism about Jett's activities was often dismissed or unspoken."

Most troubling is that Jett's misdeeds, if true, are not an isolated case at GE. When you put the Kidder scandal together with other transgressions that have sullied GE's reputation over the past decade (see "Litany of Sins"), you begin to get a sense that somewhere in the highly successful and celebrated GE culture something is not right. In response to the latest events, GE management has swooped down and made a series of high-level personnel changes at Kidder. Michael Carpenter, the 47- year-old CEO of the firm from 1989 to 1994, and a close friend of Welch's, was pressured to resign in July. A couple of weeks later, Edward A. Cerullo, 44, Jett's immediate superior and head of the fixed-income operation at Kidder, was pushed out as well. Other lesser lights also departed. In their place came Dennis Dammerman, 48, GE's chief financial officer, who has replaced Carpenter for now. Working alongside Dammerman and slated to take over Kidder once the firm has stabilized is Denis Nayden, 40, an executive vice president of GE's financial services operation, General Electric Capital Services. What these fresh faces will confront is a firm that in many ways resembles the brokerage Michael Carpenter inherited when he was tapped by Jack Welch to rebuild Kidder in 1989. Their challenge in fixing it is just as daunting. If they apply the same GE obsessions, trying to turn out high-performance numbers the way other GE businesses turn out appliances, their tenure on Wall Street may end just as badly. When Carpenter took over Kidder, securities houses were already reeling from heavy losses suffered in the market slide of 1987. But Kidder was also + struggling to recover from a scandal, this one involving one of its former investment bankers, Martin Siegel, who had been implicated in the Ivan Boesky insider-trading inquiry in 1986. Siegel's illegal activity occurred at Kidder before GE owned it, although his crimes implicated the firm because, as the SEC charged, some of the insider trading was carried on by Kidder's arbitrage staff. As part of the settlement, Kidder closed down its successful risk arbitrage department. Kidder's other businesses were only mediocre. It had a well-known retail name, but it was hobbled by high expenses and many unproductive brokers: Half the firm's retail offices produced no profit at all. Investment banking earned money, but the deals Kidder got were usually the smaller ones. Also, a number of the dealmakers had departed in early 1989 after Kidder handed out disappointing bonuses. With risk arbitrage closed down, Kidder's trading profits were drying up too. In all, the firm was on its way to a $53 million loss in 1989. Coming from GE Capital, Carpenter took up the challenge and quickly sought to impose GE's powerful business ethic on Kidder's still shaken staff. In an interview that he gave to FORTUNE in November 1993, Carpenter outlined a "six- point plan'' for revitalizing Kidder Peabody, a plan he had begun putting in place soon after he arrived. First was to reestablish the firm's total commitment to integrity. In fact, Carpenter said, "that's Nos. 1 through 10.'' Second, Kidder was to have a well-defined strategy for each business -- a GE mandate for all of its businesses. Third, he wanted to develop Kidder's people. Fourth, the firm needed to cut overhead, to become what Carpenter called "cost effective." Fifth was to develop a successful synergy with GE Capital, GE's massive financing arm and the nominal parent of Kidder. And sixth was to build a winning culture. Ambitious goals all, to be sure. Even so, as one reviews Kidder's course over the five years since Carpenter took over, it seems almost unbelievable how far short the actuality of Kidder fell from the vision he laid out. Start with that "1 through 10'' commitment to integrity. CEO Welch similarly minces no words on that imperative. Yet Welch's appointee was barely out of the starting gate at Kidder before integrity seemed to suffer a downgrade. For the first four years that Carpenter ruled the roost, he was not even licensed to manage the broker-dealer that he was charged with revitalizing. Though GE maintains that Carpenter was technically within the rules, the evidence strongly suggests otherwise (see "Was Carpenter Brokering Without a License?"). Carpenter might have been late on this score because he came in unprepared to take the required exams. But the lapse may also point to a kind of arrogance, specifically in GE's assumption that one of its senior people -- who had never worked on Wall Street but came from a background in corporate strategy -- was fit from the start to run a brokerage house.

CARPENTER was not the only one at Kidder without a license. Charles V. Sheehan, who ran retail sales under Carpenter from 1989 to 1991, was not licensed for that position. Sheehan, a former GE manager, failed to meet the most basic requirement of a broker: He never took the Series 7 exam. And a recent report in the Wall Street Journal raises questions about the licensing of one of Kidder's traders. Under Carpenter, Kidder's profitability -- the "strategy" point -- was for the most part abysmal. GE reports operating income only for the Kidder Peabody Group, the holding company, which owns some small businesses, plus Kidder Peabody Inc., the broker-dealer. In 1993, a great year for Wall Street, total profits for securities firms leaped 39%, from $6.2 billion to $8.6 billion. But if you back out Jett's $238 million of phantom profits during those years, Kidder's pretax earnings fall 6%, from $258 million to $243 million. In other words, in a year when the rest of Wall Street had blockbuster gains, Kidder's profits fell. Carpenter's strategic changes at Kidder did little to close the gap in profit margins that existed between Kidder and its rivals. Instead, he bet on boosting revenues to create high-powered profit growth, the kind that Welch makes clear GE businesses are supposed to have. To reach that goal, Carpenter set out to catapult the firm into a dominant position in the fixed-income markets, particularly mortgage-backed securities. To that end, he allowed Kidder's bond inventory to grow dramatically. In the mortgage-backed business, Wall Street firms make much of their money by underwriting the new issuance of mortgage securities. Underwriters that aggressively seek this business have to be willing to hold large inventories of these securities, the leftovers from new issues that don't sell. Like the age-old inventory accumulation problem at any retailer, it is for most an unwanted expense. High inventory also poses a risk that the value of the goods, usually financed with debt, could suddenly decline and wipe out the firm's equity. Carpenter knew those risks, but he knew too that if Kidder were willing to accept much higher inventories of mortgage-backed securities than other firms, it could grab a larger number of underwritings. He also figured that the firm could hedge part of that inventory and that, in the hands of his best traders, the inventory could become a source of enormous trading profits. Investment firms that rely solely on their own partners' capital for equity -- Goldman Sachs, for example -- would typically be a bit more cautious about shoveling debt onto their balance sheet. But with the implied financial backing of GE to draw on in emergencies, Kidder piled more and more assets on its tiny equity base. The really big push was in 1990 when the broker-dealer's aggressive underwriting helped to drive up inventory 41%, from $6.4 billion to $9.1 billion. At the end of 1993, every $1 of Kidder's equity was supporting $93 of assets, compared with average leverage for the industry of $1 to $27.

With Kidder's equity at the time a slivery $283 million, the enlarged portfolio posed a significant danger because losses on the securities would mean a big hit to the company's equity. Theoretically, a mere 3.2% decline in the value of its portfolio could have wiped out Kidder's entire net worth. But with deep-pocketed GE in the wings, it was a risk that Kidder was willing to take. All this bulking up allowed Kidder to quickly become the biggest player in the valley of esoteric mortgage-backed securities. Welch approved of Carpenter's plan to build profits from trading and underwriting. Says he: "Mike's strategy was to use these profits to build up the other businesses." In the course of 1990, Kidder more than tripled the amount of mortgage- backed securities it brought to market, from $5.1 billion in 1989 to $18.6 billion by the end of 1990, according to Securities Data, a New Jersey data service. By the end of 1993, Kidder had a market share of nearly 20% in underwriting mortgage-backed securities. Its nearest competitor, Lehman Brothers, had a 9.6% share. The leverage was paying off. After losing $54 million in 1990, profits climbed in 1991 and 1992, reaching a peak of $258 million. But many nice stories about high leverage have a nasty side too. Today, in a period of rising interest rates, Kidder stands with a huge inventory of bonds, exposed and vulnerable. The firm will need some favorable market turns and plenty of savvy trading in the coming months if it is to avoid a hemorrhage from its big inventory. Though each mortgage-backed security is unique, all are tied in some way to the price of Treasuries. And Treasury prices are down 7% so far this year. Another bad turn is coming from the drop in MBS underwritings, down 42% compared with last year. The effect of this go-for-it-all strategy was seen in the second quarter of this year, when Kidder lost more than $25 million. The firm's new chief, Dennis Dammerman, has said that he expects Kidder will break even, plus or minus $50 million, in 1994. That leaves a lot of ground to make up since so far this year Kidder is reportedly about $200 million in the hole, after tax, the result of charges related to Joe Jett, and big losses in the bond market. Factoring out the Jett-related losses, the current projection represents an enormous swing in profits from 1993. That is precisely the kind of earnings volatility Welch abhors. And that raises the possibility that despite all of Kidder's contortions to get on Welch's good list, it will ultimately be put on the block. There is some speculation that Welch, all along, had it in mind to sell off Kidder once the profits looked good. Unfortunately, Carpenter's efforts at building Kidder's other businesses have produced decidedly mixed results. Carpenter did make progress streamlining the retail brokerage and making it more cost effective. He employed GE's "Best Practices'' in the retail business and drove costs down significantly. By focusing on high-net-worth individuals and weeding out or retraining the less productive brokers, he turned the business into the most profitable parts of Kidder outside fixed-income. Says a former Kidder banker: "The retail brokerage is really worth some thing now." Given Welch's dissatisfaction with the securities business, there could be a bit of prophecy there. Other efforts to improve Kidder's businesses have been plagued by bad judgment, or at least bad timing, from the start. Much of this hearkens back to Welch's appointment of a GE man to step in at Kidder. When Carpenter arrived at the brokerage, a parade of key people in investment banking, merchant banking, and mergers and acquisitions trooped out and into their Porsches never to return. Irked by smaller bonuses and peeved that the Kidder throne had gone to another GE guy rather than Kidder homeboy and heir apparent, Max Chapman, many of the most valuable people in the firm simply despaired of GE's commitment to them and the business. Carpenter found himself with fewer and fewer people to "develop." Rumors began flying that GE would sell the company at the right price. With rumors like that going around, Carpenter couldn't get the investment banking side of the business stabilized. By the time he did, it was too late. In a monumental stroke of bad timing, Carpenter expanded Kidder's investment-banking business just as the M&A market was drying up at the end of the decade. Kidder was soon back in the rumor mill, with Wall Streeters predicting a sale or merger, possibly even to Nomura, whose U.S. operations were run by ex-Kidderite Max Chapman. In 1992, Carpenter himself was spinning the wheel, telling his executives about on- again, off-again attempts to sell Kidder to Primerica's Sandy Weill. Many Kidder bankers took the attempt to sell the company as a sign that GE was no longer interested in building up or even maintaining Kidder's investment banking business because there wouldn't be enough time to earn a return on its investment. Many of those who could, left. Nowadays, with the M&A business risen from the dead, Kidder is understaffed again, and that's hindering their comeback. Says a frustrated Welch: "They didn't get big enough fast enough.'' Was that the problem? Achieving synergy between Kidder and GE Capital -- one of Carpenter's and Welch's initial goals -- has been no more successful. As anyone who works at GE's Connecticut headquarters knows, Michael Carpenter and Gary Wendt, the CEO of GE Capital, do not get along at all. So intense and well known was the animosity that these two men felt for each other, say ex-Kidderites, that clients who wanted GE Capital to put up money for a deal would avoid using Kidder as their investment banker. Said one ex-Kidder employee: ''Hell would have to freeze over before Gary Wendt would help Carpenter succeed.'' In one display of negative synergy, Kidder, the powerhouse in mortgage securities, doesn't even make it into the ranks of the top three underwriters of the mortgage securities that GE Capital has issued this year. Rather than demand an amicable business relationship from these two, Welch had Carpenter report directly to him instead of Wendt, even though Kidder is technically a subsidiary of GE Capital. In by-the-book GE fashion, the company even hired an industrial psychologist to try to figure out ways that the two men could get along better, apparently without great success. Welch concedes that Carpenter and Wendt never got along, although he says they always acted professionally. Asked why he kept both men in place all this time, even though it made it more difficult to reap the benefits of any possible combined effort, Welch points out that the opportunity for synergy fell away as Kidder evolved into more of a trading house, a business that has very little to do with the operations of GE Capital. Basically, the big finance operation provides access to cheap money for Kidder to enable it to finance its operations. Says Welch: "The only synergies between Kidder and GE Capital are Capital's AAA credit rating.'' Wall Street analysts agree, as Kent Newcomb, a securities analyst for A.G. Edwards, wrote in a recent report, "That Kidder has never reached its expected promise, both from a synergistic and earnings return standpoint, is a plain statement of the obvious."

NOW ESSENTIAL to Kidder's success in mortgage-backed securities is Michael Vranos, 32, Kidder's mercurial and highly successful MBS trader. A Phi Beta Kappa graduate of Harvard with a degree in math, Vranos was reportedly the firm's No. 1 producer and highest-paid employee in 1993, earning some $15 million. A short, muscular man who lifts weights in his spare time, Vranos likes to break up formal meetings by engaging his table mates in arm-wrestling contests, according to one former Kidderite. The firm needs that muscle. With the mortgage securities market in turmoil, the profitability of Kidder will be riding largely on Vranos's back. This was the environment -- one of high turnover and low morale, of unlicensed and uninformed executives, of high-risk gambles in the bond markets -- in which the likes of Joe Jett and his lackadaisical supervisors played out their game. While the accusations against Jett, if proved, constitute a gross breach of trust, and could even land him in jail, it begins to become a bit clearer how a trader could accumulate $350 million in false profits over 28 months, and how one after the next, supervisors could be so easily duped. It also adds one more insight into the curious and troubling phenomenon of misadventure at GE.

BOX: A LITANY OF SINS

Kidder Peabody is not the only one of GE's businesses to be rocked by scandal on Jack Welch's watch. Herewith an unsettlingly long but incomplete list of GE's wrongdoings over the past decade. Only settled incidents are listed.

1993 GE's NBC News unit issues an on-air apology to General Motors for staging a misleading simulated crash test. NBC agrees to pay GM's estimated $1 million legal and investigation expenses.

1992 GE pleads guilty to defrauding the Pentagon of more than $30 million in the sale of military jet engines to Israel after an employee received bribes. GE pays $69 million in fines.

1990 GE is convicted of defrauding the Defense Department by overcharging the Army for a battlefield computer system. GE pays $30 million in penalties for that and other defense contracting overcharges.

1989 GE settled four civil suits brought by whistle blowers who alleged that GE cheated the government out of millions of dollars by issuing faulty timecards; GE pays $3.5 million.

1985 GE pleads guilty to fraud charges for overcharging the Air Force on its Minuteman missile contract; GE agrees to pay $2 million in criminal and civil penalties.

CHART: NOT AVAILABLE CREDIT: SOURCE: SECURITIES INDUSTRY ASSN., COMPANY REPORTS/FORTUNE CHART CAPTION: SLIM PROFITS -- Kidder's profit margin runs below its rivals.' One reason: huge inventory.