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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
guaranteed by the U.S. government not to default. The lesson from the Askin experience 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
mortgage obligations (CMOs), which are bonds whose cash flows to investors are determined by a
formula. The formula is a function of mortgage interest rates and also of the prepayment behavior of
home buyers. Since the cash flow to CMOs is a function of some other economic variable, interest
rates in this case, these instruments are categorized as derivatives. Some CMOs rise in value as
interest rates rise, whereas others fall. Askin‟s CMOs were very sensitive to interest rates. His
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 everywhere got scared and sold.
CMO prices were doubly battered 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 supported this outlook. Derivatives allowed speculators to bet on the
most likely scenario. Small bets provided modest returns, and big bets promised sizable returns. 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 series of unexpected interest
rate hikes beginning in February 1994. Citron had borrowed against the bonds Orange County owned,
and he invested the proceeds in derivative bonds called inverse floaters, whose cash flow 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.
Union Bank of Switzerland
What happened at Union Bank of Switzerland (UBS) in 1997 would be funny if it weren‟t so sad.
Imagine a bakery that sells cakes and cookies for less than the cost of the ingredients. Business would
no doubt be brisk, but eventually the bakers would discover that they were not turning a profit. This is
essentially what happened to UBS. UBS manufactured and sold derivatives to corporate customers.
Unfortunately, there was an error in its pricing model, and the bank was selling the derivatives for too