Orange County Case Report

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Orange County Case Report














On December 6 1994 Orange County announced bankruptcy with its $1.64 billion loss which
is the largest municipal loss in U.S. history. The responsible of this disaster Robert Citron
treasurer of Orange County, invested the $7.5 billion Orange County Investment Pool (OCIP)
into an interest-related portfolio (leveraged portfolios) whose yields were inversely related to
interest rates. OCIP had the county and 241 associated entities. This report introduces step by
step how Citron lead Orange County into a financial ruin and Orange County’s recovery.

What happened?
Thanks to Citron’s enviable effort OCIP had become about $7.5 billion by the 90’s. Therefore
a lot of participants in the OCIP expected to get higher returns for their idle cash. Several
millions of dollars had been created by Citron during the 70’s. Citron was free to decide
investments and he gave low priority on reporting. The public agencies too had pressure on
them not to raise taxes, but to deliver on development. This meant most of these agencies
were looking for higher returns on their funds.
Citron’s strategy was attempting to arbitrage the difference between short-term and long-term
interest rates. His position was sound and he could make money so long as short-term rates
remained low. Furthermore, Citron managed to get the best returns by taking on more risk. In
order to raies the value of his $7.5 billion pool to $20 billion he used highly leveraged
portfolios to invest his money. He accomplished this by investing in reverse repurchase
agreements, which permitted him to use securities bought by the pool as collateral for further
investments. Therefore, he would be required to provide more collateral in the event of a loss.
There was an observation committee consisted of the board of supervisors, who could not
supervise Citron because of lack of financial sophistication and lack of information. Citron
continued to his risky investments. His principal advisors for the kind of instruments he could
invest in were Merrill Lynch so Citron invested in a variety of Government paper. He also
invested in derivatives, $2.8 billion of it, in order to increase his bet on the yield curve
structure. Inverse floaters, index amortizing notes and collateralized mortgage obligationsCitron’s pool had a finger in every pie.

Due to complex investments and lack of reporting people thought that Citron knew what he
was doing and they have no idea what is going on but they were not complaining. That was
like a golden age.
Before long that feared day came when the Federal Reserve started raising interest rates. This
meant the calls for more collateral increased from his counterparties. The notional losses
increased and members of the OCIP started requesting their shares back. This resulted in the
form of a liquidity trap.

What are the responses?
The counterparties started liquidating billions of dollars of the OCIP collateral. Government
agencies invested in the OCIP started looking ways to exit. Because of this outflow the
Orange County board of supervisors declared bankruptcy to prevent investors from further
removing their funds. Although there was a public auction in the OCIP and the proceeds in
liquid short-term government stocks, losses reached to $1.69 billion.
In 18 months Orange County was able to pull itself out of bankruptcy because it took
recovery bonds and cut on its spending and social services provisions. Orange County
escaped from a position in which its weakness last forever by using stronger governance
Orange County made some radical decisions one of them was an oversight committee, an
internal auditor who reported to the Board of supervisors, written policies on investment and a
definite plan and orientation for long term financial planning. Liquidity was the most
important factor and secondary priority was safety of principal. The needs of the county by
plowing their funds for investment were certainly not for higher yields at the cost of incurring
losses. Reverse repos, structured notes and options were not allowed by the investment policy.
It requires that timely reports be presented to the board. It clearly says that any decision
making member cannot accept gifts in kind or cash.
The Orange County also reached a settlement with Merrill Lynch through litigation. As part
of the settlement Merrill Lynch had to pay the county $400 million for improper advice
towards risky instruments that were clearly at odds with the funding needs of the OCIP.

Thirty other firms that included accountancy firms, law firms also reached settlements with
the County. This money was then used by about 200 municipal agencies. These settlements
made by officers of the court reached $864 million.

As mentioned above Citron was planning to borrow short in order to go long and he invested
many exotic securities (high risk and high return). As P = y/(1+r), if r falls, P will rise and the
value of the repurchased bonds will increase which is higher than pre-determined amount, and
this instrument will gain. Thus Reverse repurchase agreements also move inversely with
interest rates. From 1989 to 1992, US interest rates were steadily declining with minor
interruptions and OCIP gained higher than normal returns. However, the Fed raised the
interest rates from 3.45% to 7.14% in order to reduce inflation and prevent overheated
In order to calculate VaR first we need to calculate duration. The average duration of bond
portfolio was 2.74 and it was leveraged by a factor of 2.7 (20.5/7.5). Therefore, the effective
duration was 7.4 (=2.7*2.74) as Effective Portfolio Duration=Ordinary Duration*Leverage
Ratio. Thus there is strong relationship between bond price change and interest rate changes.
Price = 7.5 billion, Duration = 7.04, change in i = 3.5%
By using “New P = Old P * Duration * Change in i” formula we can calculate loss
-7.5 * 7.04 * 3.5% = -$1.847 billion
This figure is different from actual loss $1.64 billion. That is because the actual duration was
amplified by the structured notes, the derivatives whose coupon payments are not pre-fixed.
Moreover, this is an approximation assumes all yields move in parallel fashion and identifies
the linear relationship between prices and yields. Thus convexity which represents curved
relationship might be more accurate to calculate the loss.
The volatility and VaR analysis have important implication for risk management of Orange
County. If volatility exceeds certain level, so will VAR. Thus Citron should adjust the

portfolio to reduce exposure to interest rate change. We apply three different approaches,
Normal method, Historical Simulation and Monte Carlo Simulation.
Normal Method: We assume confidence level as 1.65 (95%) and volatility as 0.5%.
VaR = L * Volatility * MV = 1.65 * 0.005 * 7.5 billion = 61,875 million
This means that 95% probability that Citron lose not more than approximately 62 million per
Historical-Simulation Method: We construct bins with difference of 0.5% and count how
many observations fall into each bin. At the left part of the histogram at 2.33 confidence level
(99%) there is a there is a value of 1.31%. So
VaR = 0,0131 * 7,5 billion = 98,25 million
This means that 99% probability that Citron lose not more than approximately 98 million per
Monte Carlo Simulation: This time we randomize the change in interest rate values and get
at 95% value of 0.0825.
VaR = 0.0825 * 7,5 billion = 82,5 million
This means that 95% probability that Citron lose not more than 82, 5 million per month.

What are the lessons from Orange County Crisis?
Ø In a good proceeding good recording and high performance are great. However one
should always remember that the higher the return the higher the risk
Ø A good framework is important and critical so everyone understands the organizations
investment objectives. Decision members of such investment pools should plan these
investment objectives.

Ø Organizations that invest long by borrowing short will definitely have to face liquidity
Ø Thanks to a framework of investment policies, guidelines, and risk reporting and
independent and expert oversight can help make a good union of risk-averse investors
with investment objectives to investment actions.
Ø It is fundamental to prepare clear and easy risk reports that are understandable by all
parties. This way all parties concerned will be on the same page with regards to what
is happening to the investments. Complicated instruments or strategies that cannot be
explained to third parties must be avoided, particularly by the risk averse.






































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