Infectious Greed (23 page)

Askin's strategy sounded just like that of Salomon's Arbitrage Group.
Askin told investors the fund had “proprietary analytic models” that identified mispricings among complex mortgage securities, such as Collateralized Mortgage Obligations. The fund then bought the cheap CMOs and sold the expensive ones, just like Greg Hawkins of Salomon Brothers.

The funds within Askin Capital Management had rock-solid names, such as Granite Partners and Quartz, and solid returns, too, which attracted hundreds of millions of dollars of investment. New investors ranged from Nicholas J. Nicholas Jr., former CEO of Time Warner, to the 3M Employee Retirement Income Plan.
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General Electric and its chairman, Jack Welch, also were involved in Askin through Kidder Peabody.

Askin bought many of the same securities Worth Bruntjen of Piper bought, including hundreds of millions of dollars of inverse IOs, sold by Kidder Peabody, which General Electric owned. By 1994, Askin had become such a big player that the market for exotic mortgage derivatives simply could not function without the fund. Bruntjen was dependent on Askin's trading of complex CMOs; without it, the market would dry up, and the price of the securities would plummet.

After the rate hike, Bruntjen's fund had lost a great deal of money, but Askin was in much worse condition. The fund was stuck with long-maturity securities that paid virtually nothing, and Askin had borrowed money to leverage its positions. As the markets went down, Askin needed to sell CMOs to repay some of the loans. But when the firm began selling, the sales created a downward spiral in the CMO market, with prices dropping so low that many dealers refused to trade at all.
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Askin also was a victim of the same kinds of valuation problems that had plagued Bankers Trust and Salomon. When the Fed raised rates on February 4, the Granite fund used its own computer models to determine the value of its mortgages, instead of looking to the market for values. As the markets declined, Granite's computer models said that the market was wrong, and that the mortgages were still valuable. Granite did not mark to market its securities based on reliable, outside data. Instead, it valued its portfolio based on the computer's outputs.

Askin survived briefly because of the fund's cozy relationship with brokers. The brokers made millions from Askin's purchases, so they gave the fund favorable lending terms, and even allowed Askin to take possession of securities he had not yet paid for. As described in the previous chapter, the value of a mortgage derivative depended greatly on assumptions about how quickly homeowners were prepaying their mortgages; with this flexibility, brokers could give Askin favorable
mark-to-market numbers, to help justify relying on the fund's computer outputs, and thereby smooth the fund's income and, potentially, hide losses. In describing the special consideration David Askin received, one investor called him “the Hillary Clinton of the bond market.”
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(This was a reference to Hillary Clinton's foray into cattle-futures trading, where she netted $100,000, allegedly because her broker had allocated only winning trades to her account.)

The special treatment helped at first. When Askin reported its February 1994 results to investors, there appeared to be only a two-percent loss. But a few weeks later, when Askin obtained some less friendly marks from other dealers, the loss was 20 percent. In late March, Askin told investors the loss was 35 percent.
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At this point, it appeared that Askin might not be able to repay its loans. Askin's brokers—fair-weather friends—abruptly abandoned the fund and began issuing
margin calls,
demanding that Askin repay the money it had borrowed. When Askin couldn't repay the loans, brokers sold Askin's CMOs—just as Orange County's brokers had sold its structured notes. The CMO markets crashed, destroying not only Askin, but Worth Bruntjen and numerous other investors. By April 7, all $600 million of Askin's fund was gone.

Throughout this time, Askin was paying huge fees for the CMOs it purchased. Either Askin was overpaying its brokers and hoping for favorable treatment, or it was no more sophisticated than Worth Bruntjen. The first possibility raised troubling questions about conflicts of interest. But the second possibility—that the Askin fund's emperor had no clothes—was more likely. It was difficult for any fund to impersonate Salomon's Arbitrage Group, and Askin apparently had failed.

Taped conversations among salesmen at Kidder Peabody, then the leading CMO dealer, confirmed this second view. After the Fed's rate hike, Kidder's mortgage salesmen were hurting, because trading in complex mortgages had declined. The salesmen passed the time by mocking Askin, just as Bankers Trust salesmen had mocked Procter & Gamble. Kidder had sold Askin hundreds of millions of dollars of CMOs during the weeks before
and after
the Fed's rate hike, just as Bankers Trust had sold swaps to P&G during February 1994, and Kidder had made even more money than Bankers Trust from the sales.

Here is a record of one conversation alleged to have taken place between William O'Connor, the Kidder salesman who covered Askin, and his assistant, Jay Pappas, on March 25, 1994, just seven weeks after the
Fed's rate hike, in the heat of the uncertainty about whether Askin would survive:

To translate: Wall Street was making just as much money from sales to Askin as it was making from sales of similar instruments to municipalities and mutual funds. Interestingly, the brokers fed on Askin, as it lay dying, just as they had picked at Orange County after its bankruptcy. Howard Rubin—the trader who had lost $377 million for Merrill Lynch in 1987 and then resurfaced, unpunished, at Bear Stearns—was one of the vultures, along with traders from Kidder Peabody. It appeared that Kidder Peabody and Bear Stearns were “cooperating” to buy Askin's bonds at fire-sale prices, just as the structured note dealers seemed to have colluded in buying Orange County's bonds. William O'Connor of Kidder reportedly said that “basically we told Howie Rubin, we'll bid all your bonds, you got to bid all ours, we just need legal for court later on.”
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The dealers apparently had plenty of “legal”—meaning they believed they could defend each other's low valuations as lawful and appropriate—and they were never punished for these actions. Howard Rubin and Bear Stearns allegedly made $20 million in a few days, buying and then reselling Askin's CMOs.
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Askin filed for bankruptcy a few days later. The fund had been able to survive pretending to be Salomon's Arbitrage Group for only about a year.

Askin's troubles were terrible news for Worth Bruntjen, who was struggling to evaluate the damage done to his fund. By March 1994, Piper was unable even to determine end-of-day prices of the assets in Bruntjen's
fund on a daily basis, as required by law. Bruntjen and his staff had switched to a weekly pricing procedure—comically dubbed “Pricing Thursdays”—in which they would attempt to evaluate the prices of all of their instruments by calling various financial institutions and plugging data they often didn't understand into computer models.
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During early April 1994, the pricing procedure took most of the day.
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Like Askin, Piper did not disclose the risks associated with these complex instruments, or the difficulties of pricing them. At Piper, the problems were not even disclosed to employees outside Bruntjen's circle, or to many of the salesmen who had sold so many millions of dollars' worth of Bruntjen's fund to their accounts. Piper employees later would express shock when they learned that Bruntjen had not been such an expert in mortgage derivatives. Many people had assumed that Bruntjen's background was similar to those of the traders and Ph.D.s at Bankers Trust, First Boston, and Salomon Brothers. But the reality was that Bruntjen was far from a “rocket scientist”—he did not have a college degree, and he certainly did not have the training necessary to understand complex CMOs.

The supposedly ultra-safe mutual funds Worth Bruntjen managed at Piper were the worst-performing bond funds in the entire market in 1994. Bruntjen was down 28 percent for the year, an inexplicable loss for a short-term government-bond fund that advertised preservation of principal. John Rekenthaler, editor of Morningstar—which had given Piper its highest ratings—said that although Piper had claimed Bruntjen's fund was short-term in nature, “the fund had to be a hell of a lot longer.”
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Yet these longer-maturity risks, embedded in highly rated CMOs, had been invisible to fund investors.

In September 1994, CEO Tad Piper maintained that the instruments Bruntjen owned were still undervalued, and said he believed the fund would come back. He admitted that the fund “got caught in a market that we thought we understood,”
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but insisted that “we have great confidence in Worth.”
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He did not explain how a conservative government-bond fund could lose 28 percent in less than a year, or how it previously could have averaged returns of more than 13 percent for several years. In any event, Tad Piper would not be taking Worth Bruntjen on any more ski vacations. Bruntjen would continue to work for Piper only until just after the lawsuits against his firm were resolved. Bruntjen settled the SEC's case against him by agreeing to be barred from the industry for five years. He paid a $100,000 fine.
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L
ike Orange County and the various municipalities, Piper was far from the only mutual fund at the gambling tables. In the early 1990s, managers of many of the largest mutual funds in the world had placed similar, hidden bets, using various types of derivatives. The bets included not only structured notes and mortgage derivatives, but novel variations on the currency derivatives Andy Krieger had pioneered. For example, the Alliance North American Government Income Fund—then one of the largest and best-performing bond funds in the world—had placed large bets on the Mexican peso, which had remained stable relative to the U.S. dollar for several years. For years, the bets had paid off, and Alliance's fund was the best performer in its category. (The aftermath of the peso devaluation of late 1994 is covered in Chapter 8.)

The major money-market funds—which had bet on U.S. interest rates, just as Orange County and Piper had—did not fare as well. Money-market funds were supposed to be ultra-safe, basically a substitute for cash or a checking account. Yet several banks were forced to prop up the money-market funds they managed, in order to avoid losses, including such major funds as BankAmerica ($68 million), First Boston ($40 million), Merrill Lynch ($20 million), and PaineWebber ($268 million).
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As if Kidder Peabody's bad year selling mortgages hadn't been bad enough for Jack Welch, the chairman of General Electric—Kidder's parent company—Welch also had to spend $7 million to cover derivative-related losses in five of Kidder's money-market funds.
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Atlantic Richfield Company's ARCO managed a $400 million money-market fund, and lost $22 million.
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United Services Advisors lost $93 million,
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Fleet Financial Group lost $5 million. And so on. In September 1994, a money-market fund called Community Assets Management Inc., in Denver, was liquidated, and there was no parent company to make up for losses. Community Assets became the first-ever money-market fund to lose money for its shareholders.

On June 1, 1994, Edward C. Johnson III, chairman of the Fidelity family of mutual funds, sent a letter to all of Fidelity's bond investors, explaining the funds' use of derivatives and blaming the recent losses on the interest-rate hike and the role of leveraged hedge funds, which he said “were caught by surprise by the magnitude of the rise in interest rates and the decline in bond prices and were forced to sell to meet margin calls.”
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Fund giant Vanguard distributed a similar notice in a bulletin called “Plain Talk About Derivatives.”