Corporate & Securities Law

1994 - WHEN MORTGAGE-BACKED SECURITIES TURNED ILLIQUID IN THE BLINK OF AN EYE.   

In 1994, the market for mortgage-backed securities crashed.  The ensuing liquidity crisis took down investment advisor David Askin's leveraged mortgage securities fund.  Ultimately, the MBS crisis of 1994 led to massive Wall Street losses and the dismantling of investment bank Kidder Peabody.  

By Brett Sherman

What happened to the lessons of 1994? 

That year, a small and unexpected interest rate hike crippled the mortgage-backed securities market with astonishing speeed.  As was the case in mid-2007, the market for mortgage-backed securities virtually disappeared.  Like 2007, investors holding mortgage bonds lost big, and so did the investment banks that sold them.  

Why do so few of us remember the mortgage securities crisis of 1994?  

Because the MBS market was a fraction of the size it was during the recent housing and credit bubbles. In 1994, most people outside the world of finance had even heard of mortgage-backed securities. But Wall Street knew all about them. In the early 1990's, as in recent years, investment banks booked tremendous profits from the sales of MBS.

How significant could the 1994 crash have been? 

Very significant.  

Before the 1994 crash,mortgage-backed securities /CDOs accounted for roughly one-third of the total US bond market. 

The big three Wall Street producers and sellers of mortgage-backed securities were Kidder Peabody, Bear Stearns, and Lehman brothers. All three firms (as well as many others) took big hits when the MBS market evaporated in 1994. 

Kidder Peabody's mortgage-related losses led to the firm's demise.  Kidder's parent company, GE, shut down the legendary firm and sold off pieces of Kidder Peabody to the highest bidders. 

The crisis also ruined hedge fund manager David Askin. Askin ran a leveraged fund that held mortgage-backed securities. When the mortgage securities market started to collapse, Akin's creditors grew uncomfortable accepting nearly illiquid MBS as collateral for the large loans Askin's MBS fund needed to finance its holdings and stay afloat.   

As the 1994 crisis deepened, buyers for mortgage-backed-securities grew more and more scarce. Askin's creditors issued margin calls.  Lenders demanded more and less risky collateral to secure the loans. Askin could liquidate enough of the fund's holdings to meet these margin calls. 

As Askin's clearing agent, Bear Stearns was one of the fund's creditors that demanded additional and higher quality collateral.  Once it was clear that Askin could not meet creditors' demands, the race to seize assets was on and Askin's MBS fund collapsed.  Reportedly, the first firm to seize assets from Askin's mortgage-backed securities fund was Bear Stearns, then in its second calendar year under CEO James E. "Jimmy" Cayne.

The similarities are striking between the collapse of Askin's leveraged MBS fund and the bankruptcy of two Bear Stearns leveraged MBS funds roughly 13 years later (indeed, the collapses of the Askin and Bear MBS funds were microcosms of the subsequent failure of Bear Stearns itself in 2008).  

Although Bear Stearns and Lehman Brothers were prime players during the 1994 mortgage securities crisis, and had front row seats for the demise of Kidder Peabody, Jimmy Cayne and Dick Fuld apparently blocked out painful memories from 1994.

Why did Wall Street ignore the lessons of 1994?

Maybe it had something to do with immense profits and huge compensation...  Ya think?