In the late 1980s, Wall Street redefined the all-American dream of home ownership. That was no longer to be just a cozy, green-clapboard Cape Cod–style home, with a tree house for Jimmy in the backyard and maybe a babbling brook somewhere on the premises. None of that crap. Wall Street was focusing on something a great deal more important—the income stream from the mortgage secured by that cozy, green-clapboard Cape Cod–style home. You too could own a piece of your neighbor’s mortgage. You might not have the fun of sending a nasty note when your neighbor is a day late with his monthly payment, or enjoy the thrills of foreclosure if he loses his job, but you could enjoy a portion of the principal and interest stream from that mortgage. When the mortgage was finally burned in the fireplace, a little bit of you would go up the chimney.
Wall Street brought the blessings of home-mortgage ownership to all Americans by a process known as securitization. What that means is simple enough in principle, though the execution can be a bit messy. You take a contract that generates cash, and use it as the basis for a security that can be bought and sold on the open market. Securitized mortgages had been around since the 1970s, when government housing programs such as Fannie Mae started packaging them, but it wasn’t until the late 1980s that Wall Street got really whipped up into a frenzy about them. Securitized mortgages had everything you could want from a financial vehicle: great gas mileage, plush interior, mag wheels—and, above all, high commissions. The leading manufacturers started cranking them off the assembly line. The Big Four were investment banks with large marketing arms that knew their way around a showroom and had a sterling reputation: Merrill Lynch, Bear Stearns, Drexel Burnham Lambert, and, right at the top of the list, the champion mortgage repackager of them all, Kidder, Peabody & Co.
Quite a bunch: a retail-wholesale powerhouse, an Eddie Haskell–like trading outfit, an even more mischievous junk bond merchant, and a firm that had gone through some rough spots (such as one of its brokers’ involvement with Wall Street Journal insider-trader R. Foster Winans) but was now doing quite well.
Securitized mortgages—known as collateralized mortgage obligations, or CMOs—included both straightforward mortgage pools and all kinds of variations designed by the aforementioned brokerages. One of the things they did that made things more complicated—and profitable—was to peel off the interest from the principal, and sell the two separately. As any junkyard operator in East New York can tell you, a stripped car is worth more than the sum of its parts. It’s the same thing, more or less, with mortgages.
Well, you know what happens when Wall Street wants to make a few bucks: The usual bad-mouthing resulted. The Chicago Tribune reported in September 1987 that “some” were on the loose again. Fortunately, the Trib had an expert on hand to refute them. “Some view these strange investment vehicles as ‘Wall Street foisting speculative time bombs off on unsuspecting investors,’” said the Trib, quoting David J. Askin, “vice president and manager of the fixed-income research department” at Drexel Burnham. Not true, said Askin. The newspaper went on to say that, the views of “some” to the contrary notwithstanding, mortgage-backed securities were high-yielding and, above all, “safe.”
The people who bought CMOs included some ordinary retail investors, but the primary market consisted of professional investors and traders for major investment houses—people brainy enough to understand the complexities of stripping and hedging and duration and risk and beta and theta and portfolio balancing. Among them were hedge funds, and by September 1991, one of the managers of a leading CMO hedge fund was that same David J. Askin.
Askin took over the management of a hedge fund called Granite Partners. In the coming months, there would be other CMO hedge funds, but Granite was always the biggest. Everything went just fine. In 1993, the Askin funds climbed 20 percent. After all, Askin was a twenty-four-carat mortgage-securities whiz, and he attracted twenty-four-karat investors—Nicholas J. Nicholas Jr., former CEO of Time Warner in its pre-AOL days; James L. Gray, former president of Warner Cable Communications; Playboy Enterprises chief financial officer, David I. Chemerow; the 3M Employee Retirement Income Plan; and even the Salami King of the Bronx, Isidore Pines, who ran the Hebrew National kosher food company.
These were wealthy people and institutions that were careful with their bucks, and, judging from Askin’s résumé, he was about the best guy they could have running their securitized-mortgage portfolios. He had impeccable academic credentials, and he had risen through the ranks at first Merrill Lynch and then Drexel, where he developed what an official postmortem later described as “proprietary models for fixed income investing and was widely regarded as a quantitative oriented manager, with particular expertise in evaluating mortgage prepayments.”
And then…Granite lived up to its name. The Askin funds were in Hedge Fund Memorial Park, all laid out neatly in adjoining plots. It was over. Sudden, quick, but not painless.
In April 1994, the Askin funds declared bankruptcy. Most of their $1.6 billion in CMO portfolios, as magnified by three-to-one leverage, had gone away. Poof!
How in heaven’s name did that happen? After all, mortgage-backed securities were “safe,” as no less an expert than David J. Askin was happy to admit. Besides, Askin was running Granite, Quartz et al. under optimal circumstances, such as existed only in hedge funds. As we saw in the last chapter, hedge funds are, in theory, an outstanding way of managing money, and Askin put that theory to practice. He was incentivized up the wazoo. He had as much freedom as a twenty-pound alley cat. He and his colleagues in hedge-fund-land had made the hedge-fund business model even more fantastic than it had been when A. W. Jones and Warren Buffett were slogging away at their buy-and-short strategies.
Askin worked out all the kinks, and by the time his funds conked out in April 1994, hedge funds were a lot better than the clubby, intimate, tweed-jacket kind of operation that they had been just a few years before. Only the good stuff (the so-high-you-get-dizzy fees and go-out-and-have-fun investment latitude) was retained. The bad stuff went out, and good riddance!
The really bad stuff had to do with that word hedge. No hedging for these guys. The Salomon Brothers bond-trading fiasco had demonstrated, for anyone who had cared to notice, how much fun hedge funds could have if they stopped hedging—how they could enjoy the benefits of even a rigged market and get away with it. They didn’t have to tell the regulators, or even their investors, a damn thing they were doing. They were accountable to no one. Sure, there was regulatory heat from the Salomon disaster, but it was worth it. Hedge funds were able to exhibit the kind of screw-you attitude that is rarely found among money-making enterprises anywhere, except for maybe Colombian drug gangs or the Gambino crime family.
In 1990, according to some of the unreliable statistics then available, about 70 percent of hedge funds made money the old-fashioned way, by going long and short simultaneously. Then the erosion began, and hedging gradually faded away—to the point that by 2005, with the fund industry immensely bigger, “traditional” hedge-funds-that-hedge represented just one-third of all funds. Of course, since hedge funds are free to leave their investors in the dark and do pretty much whatever they want regardless of what their ostensible “style” may be—Long-Term Capital Management was an outstanding example of style-disregarding—no one can really say how many long-short hedge funds were still hedging.
Another stodgy convention that had become totally passé much faster, and was pretty much history by the early 1990s, was that old-fashioned, buck-stops-here “general partner is liable if anything bad happens” philosophy that helped keep fund managers on the path of righteousness in the old days. By the early 1990s, hedge funds everywhere were following the kind of good legal advice that was given by Arnold & Porter at that presentation in October 1993. No hedge fund manager was going to do anything so brain-dead as accepting personal responsibility if anything bad happened. The general partner of the flagship Granite Partners was another limited partnership, Askin Capital Management, and the general partner of that was something called Dashtar Corporation, with Askin finally materializing as the general partner of Dashtar. (The origins of the name are not known, but one might suspect it was a subliminal salute to the Dustin Hoffman–Warren Beatty disaster Ishtar, arguably the worst movie ever made.)
Just to make sure that nobody got confused on this liability point, the Granite fund made use of belt-and-suspenders language that was already popping up in hedge fund documents throughout the land. Investors in the fund agreed, when they plunked down their $1 million minimum investment, that they would “indemnify and hold harmless the partnership and General Partner and their Affiliates, officers, employees and agents to the extent permitted by law, for any and all costs, expenses, liabilities or losses (including legal expenses) which the indemnified party may incur under ERISA or otherwise if and to the extent…” and on and on. Combine that gem with other standard language allowing Askin to do anything he wanted, including parboiling the firstborn of his partners, and you get the general idea of the kind of glorious freedom Askin enjoyed.
Which is not to say that he made use of all of his freedom. Granite was supposed to be market neutral, which meant that it would achieve its stated objective of a stable 15 percent annual rate of return no matter what was happening in the bond market. The evidence suggests that he actually hewed pretty close to the fund’s stated objective, or at least tried to do so.
Askin made every effort, apparently, to balance bullish securities with bearish securities, just as one would expect from a good hedge fund manager adhering to the A. W. Jones tradition. Askin later told the Bankruptcy Court trustee examining the funds’ demise that, dyed-in-the-wool quant that he was, he used a “proprietary prepayment model” to help him buy stocks, as well as “sophisticated tools to select securities and balance his portfolio.”
With all those sophisticated tools and models, it stands to reason that when the Fed raised short-term rates on February 4, 1994, Granite was as hedged against disaster as a bookie joint at Super Bowl time, and ready to withstand the punishment—not.
Something peculiar happened. We know that something peculiar happened only because of the exhausting and well-compensated labors of that Bankruptcy Court trustee, former New York City comptroller Harrison J. Goldin, who was paid a few million bucks to turn out a 375-page report in 1996. By then, the Granite mess was a kind of wretched memory and nobody much cared except for its creditors, their lawyers, and the accountants and experts who were paid to care.
The trustee, his lawyers, and his accountants pored over every scrap of paper involved in the life and death of the Askin funds, and actually hired Askin himself as a consultant to help the trustee figure out how he made a mess of things. The trustee’s conclusion, after two years of dogged research with the assistance of the mess-maker himself, was that the biggest hedge fund disaster up to that time had occurred because there had been a misunderstanding somewhere along the line. That’s right—a goof.
Apparently, just as you might pick up a quart of buttermilk at the store thinking it was eggnog, Askin bought securities that weren’t what he thought they were. It seems that Askin thought his Granite fund was composed of securities that made it market neutral. But—uh-oh!—it wasn’t. Darn it. His fund actually had a “bullish tilt” and was thus vulnerable to increases in interest rates, such as took place in February 1994. It seems that Askin, the toast of the quant world, actually “lacked adequate quantitative tools to measure that tilt.”
As for that “proprietary prepayment model” that Askin said he had—well, Goldin respectfully disagreed with his consultant on that point. It’s not that Goldin thought the model wasn’t good enough. He didn’t think it existed. Goldin reported that he couldn’t find any evidence that there really was such a thing.
Some of the buttermilk that Askin thought was eggnog went by the name of inverse IOs. These were exotic CMO derivatives that tended to decline when interest rates rose. They were real stinkers to have in your portfolio when, say, the Fed decided to increase rates. Goldin found that Askin “may also have been misled by certain broker/dealer sales representatives” to believe that the inverse IOs were actually good things to own when rates went up. Goldin went on to say, in a kind of carefully worded kick in Kidder Peabody’s posterior, that the funds could make a good case for misrepresentation against Kidder. The latter swiftly denied any naughtiness. Still, Askin might have wanted to take back what he said to the Trib in 1987, when he debunked that myth about “Wall Street foisting speculative time bombs off on unsuspecting investors.”*
You have to admit, there’s a certain charm in all this. If you rip away the MBA and the quant background and all the years analyzing and measuring and weighing mortgage-backed securities, it seems that Askin was just another guy in a green-clapboard Cape Cod, helpless before a fast-talking broker. As portrayed in the Goldin report, Askin was a kind of unsophisticated Rand Groves who was led down the garden path by his brokers. He bought stuff that he thought would zig when it was really supposed to zag. Could have happened to anyone.
In fact, shortly after the collapse, Askin’s lawyer repeated a refrain familiar to schlepper investors everywhere—Wall Street was to blame. His client, he maintained, was forced out of business, with Askin in roughly the position of a homeowner who doesn’t get much slack from the bank when he falls behind on his mortgage payments.
There was some basis for this complaint. After the Askin funds declined 20 percent in February 1994 (though he goofed there too and told investors it was just a 1 to 2 percent decline), his investors started to pull the plug—and so did those brokers who had sold him stuff on credit. Acting with the kind of compassion usually found among easy-terms furniture salesmen, Askin’s brokers called in the repo man. They socked Askin with a margin call, which is precisely what happens to you if you buy stock on credit and the price starts sinking and your account lacks sufficient collateral. If you read the fine print on the margin agreement, you’ll find that the broker has the right to force you to put up more money, or to sell the stock. Askin tried to come up with the money, but he didn’t have any luck because his clients were cashing out.
As Goldin gently put it, the “broker/dealers were unwilling to forbear exercising their contractual rights to liquidate the collateral upon the Funds’ default.” The brokers rented some U-Hauls, loaded up their IOs and the other cardboard-furniture merchandise, and the Askin funds were kaput. The brokers sold all those CMOs that they repossessed, thus depressing the market for CMOs generally and making the market for that stuff a lot less hot than it used to be. To make everything messier, as things went down the tubes Askin often guessed at the prices of the securities in his portfolio. That goes by the euphemism of “manager marks,” which you have to admit sounds much nicer than “guesses.” These were not accurate guesses, so his doing this did not make investors feel very affectionate toward him. But, then again, they didn’t like the man very much anyway, not after he lost so much of their money.
One bright spot emerged from all this: The cause of higher education was advanced by the Askin disaster. Since Askin’s brokers did not dot all the i’s and cross all the t’s as they cashed in all those CMOs, lawsuits were filed that dragged on through 2003. The resulting legal fees sent a whole generation of law firm partners’ progeny through prep school and college.
There were no other silver linings because there were no consequences. Every parent, puppy owner, and victim of a financial disaster knows that without consequences a mess is going to happen again. Nobody involved in the Askin mess—not the hedge fund industry, not the investors therein, and certainly not the self-regulatory pyramid—learned a thing from it. That would have been enough, by the way. Not a ton of new regulations, just an understanding of what had happened, and a determination not to repeat it.
Didn’t happen.
That was not for want of resource material. Thousands of acres of virgin woodland were swept off the face of the earth by the public record spewing forth from the Askin saga—a trustee report that’s longer than this book, plus several thousand pages of filings in various courthouses by the aforementioned law firms, all about the Rise and Fall of David Askin. They are a veritable MBA course in the business practices of hedge funds and Wall Street firms.
Reduced to its essentials, the Askin failure could be deconstructed as follows:
A number 6 might have been applicable at some point if Askin hadn’t been run off the road by his brokers. The Askin funds, like most hedge funds, had high-water marks that don’t allow a fund manager to take that 20 percent incentive fee until he makes up for losses in previous years. So if a fund manager runs a hedge fund that declines 10 percent one year, he has to push up the portfolio 11.1 percent before drawing a nickel in incentive fees. This sounds terrific, but in reality it sucks.
The high-water mark penalizes managers who engage in volatile investment strategies, in theory. In practice, it is the functional equivalent of handing out cyanide pills to people in depression clinics. Over the years, it has become nothing more than an encouragement for fund managers to close their funds. It’s easy—just a few documents need to be filed with the state corporate-filings office, and of course the fund documents don’t make the suicide process at all difficult.
You can’t blame fund managers for putting an end to their funds when things go bad. After all, nobody wants to work for bupkis. They don’t want to recoup old losses. That’s just a marketing gimmick. They want a fresh start, so they can start charging fees again as if nothing happened. The old investors? Well, they’re accredited and sophisticated, so they’ll understand.
Hedge funds are prone to suicide because they are volatile. The old nursery rhyme sums up their fate: When they are good they are very, very good, and when they are bad they are horrid. Askin did a decent job when the market was doing well. When the market wasn’t doing so well, as happens sometimes with hot markets like mortgage-backed securities, Askin was horrid because he was leveraged to the hilt with the wrong stuff. He wouldn’t have been so horrid if he had been structured like…well, like a hedge fund. An old-fashioned hedged, long-short hedge fund.
The Askin meltdown caused a brief flurry of activity within the self-regulatory pyramid. A task force was organized by the President’s Working Group on Financial Markets. The task force chewed things over for a few months and in September 1994 issued a report. It made a bunch of findings, of which two deserve highlighting: (1) hedge funds “could exacerbate market movements if the funds need to sell to meet margin calls or unwind leveraged positions”; (2) “It may be difficult for banks and broker-dealers to monitor the creditworthiness of hedge funds because they do not typically know the overall positions of hedge funds, which can change rapidly.”
Four years after those words were written, Long-Term Capital Management put the financial system in jeopardy by following fairly closely in the footsteps of Askin and Granite. Rather than repeat the oft-told tale of LTCM, let’s just examine the template at work here. Once you have the template, all you have to do is fill in the blanks:
Other parts of the template were unchanged:
The Askin Template is not the only template out there in hedge-fund-land. There are a bunch of others, some quite original but most of which had the very same elements that were established way back in 1994, when the Askin funds went belly-up. So study the list below carefully. All of these templates need to be kept in mind if you are one of those lucky accredited investors, or if your pension fund or college endowment is invested in a hedge fund:
The first Superinvestor to blunder into the last template was Michael Steinhardt. He shut down his massively hyped $2.6 billion hedge fund group after making a massively arrogant wrong-way bet on overseas bonds, which caused his fund to sink 30 percent in just three months of 1994. His fund stayed in the toilet, and he shut it down in September 1995. He ended that year up 26 percent—which looks great until you realize that the S&P 500 had a 37.6 percent total return, after which it doesn’t look so great. In fact, it looks lousy. Steinhardt bugged out despite not having a high-water mark—demonstrating that ego alone can turn an overhyped investment superstar into a former overhyped investment superstar.
The next überinvestor to stick his foot in the “EMH trap” was my old pal Julian Robertson, * who shut down his even more humongously hyped Tiger funds in early 2000 as a result of lousy stock picking that caused him to pull off a considerable feat—double-digit losses at a time when the major stock indexes were racking up record gains. His funds peaked in August 1998, and investors found their Tiger holdings sliced nearly in half by the end of February 2000. Julian managed to take a fund group that had $23 billion in net assets in 1998 and turn it into a shriveling, on-the-run $6 billion fund group (after redemptions) in early 2000. Yep, it takes a really active portfolio manager to accomplish that during the biggest bull market in history. Later that year, George Soros and his loyal sidekick Stanley Druckenmiller (a kind of reflected-glory Superinvestor) had to reorganize the Quantum funds after being caught, hedgeless, in the tech-stock bust.
The hubris and the stupidity and the arrogance have continued to this day, filling template after template. You may even read about them in the back pages of the newspapers now and then, while the front pages chronicle how hedge funds have become the youthful, zestful Robin Hoods of Wall Street. Literally. Hedge fund managers organized the modestly named Robin Hood Foundation, which has an annual ball that has become a leading Wall Street social event. (Kind of makes you wonder how they’d feel about a real-life Robin Hood waylaying them on Dune Road.) Hedge fund managers have climbed to the highest rungs of the social ladder much as did investment bankers during the 1980s. It’s all great stuff—until they fail. And fail they will, consistently.
According to the Malkiel-Saha study, the average lifespan of the live hedge funds surveyed was sixty-two months. The average life of the dead ones was five years, with fund failures reaching a maximum at forty-eight months. As Saha observed at a seminar outlining his study, “failure is a real and palpable possibility for many hedge funds.”
All of this makes hedge funds arguably one of the smartest, snazziest, sexiest things you can do with your money—as long as you don’t mind losing it, either through high fees or dim-witted, arrogant investment strategies or even flat-out thievery. There’s really not much doubt at all that an index fund you buy over the Internet is likely to do better than a hedge fund, and has the added virtue of being far more liquid and way, way less likely to fail. Buying an index fund, however, will not give you status. It does not provide scintillating cocktail party chatter, unless all involved have been drinking and have other things on their minds.
Unfortunately, status is not the only issue involved here. As first Askin and then LTCM proved, all that status has a price. Unrestrained trading by hedge funds is capable of dragging down the entire financial system. That hurts everybody, whether you are sophisticated, accredited, or keep your money in a tin box; whether you are driven by status or greed, are an efficient-markets maven, an advocate of behavioral finance, or perhaps just an ordinary person who wants to be left alone.