428 Planning and Forecasting
Askin Capital Management
Between February and April 1994, David Askin lost all $600 million that he
managed on behalf of the investors in his Granite Hedge Funds. Imagine the
surprise of the investors. Not only had they earned over 22% the previous year,
but the fund was invested in mortgage-backed securities—instruments guaran-
teed by the U.S. government not to default. The lesson from the Askin experi-
ence, is that in the age of derivatives, investments with innocuous names might
not be as safe and secure as they sound.
The particular type of mortgage-backed securities that Askin purchased
were collateralized mor tgage obligations(CMOs), which are bonds whose
cash f lows to investors are determined by a formula. The formula is a function
of mortgage interest rates and also of the prepayment behavior of home buy-
ers. Since the cash f low to CMOs is a function of some other economic vari-
able, interest rates in this case, these instruments are categorized as
derivatives. Some CMOs rise in value as interest rates rise, others fall. Askin’s
CMOs were very sensitive to interest rates. Askin’s portfolio rose in value as
interest rates fell in 1993. When interest rates began to rise again in February
1994, his portfolio suffered. Interest rate increases alone, however, were not
the sole cause of Askin’s losses. As interest rates rose and CMO prices fell,
CMO investors every where got scared and sold. CMO prices were doubly bat-
tered as the demand dried up. It was a classic panic. Prices fell far more than
the theoretical pricing models predicted. Eventually, calm returned to the
market, investors trickled back, and prices rebounded. But it was too late for
Askin. He had bought on margin, and his creditors had liquidated his fund at
the market’s bottom.
Orange County, California
Robert Citron, treasurer of Orange County, California, in 1994, fell into the
same trap that snared Procter & Gamble and David Askin. He speculated that
interest rates would remain low. The best economic forecasts at the time sup-
ported this outlook. Derivatives allowed speculators to bet on the most likely
scenario. Small bets provided modest returns. Big bets promised sizable re-
turns. What these speculators did was akin to selling earthquake insurance in
New York City. The likelihood of an earthquake there is very small, so insurers
would almost certainly get to keep the modest premiums without having to pay
out any claims. If an earthquake did hit New York, however, the losses to the
insurers would be enormous.
Citron bet and lost. The earthquake that toppled his portfolio was the un-
expected interest rate hikes beginning in February 1994. Citron had borrowed
against the bonds Orange County owned, and he invested the proceeds in deriv-
ative bonds called inverse-f loaters, whose cash f low formulas made them extra
sensitive to interest rate increases. Citron lost about $2 billion of the $7.7 billion
he managed, and Orange County filed for bankruptcy in December 1994.