OtherPapers.com - Other Term Papers and Free Essays

Orange County

Essay by   •  December 18, 2011  •  Essay  •  956 Words (4 Pages)  •  1,058 Views

Essay Preview: Orange County

Report this essay
Page 1 of 4

Orange County

In December of 1994 the financial markets were stunned by a bankruptcy filed by Orange County, California. This was the largest municipal bankruptcy in U.S history, with their portfolio suffering losses of 1.6 billion dollars. The losses were the result of trading activity by the county treasurer Bob Citron. He was not formally educated in finance and was left unsupervised to bring returns to the taxpayers of Orange County. He was able to achieve this goal until 1994 when things took a turn for the worse and OCIP's profitability plunged. I'm going to show you; how Citron was able to earn above average returns, the different risks the portfolio faced, and how the lack of supervision came into effect.

Citron was able to earn above average returns for Orange County when the interest rates were falling, and deliver the investors a return 2% higher than the state of California's fund. Citrons investment strategy was concentrated on betting big that interest rates would fall or stay low. At the time interest rates were doing exactly this, which allowed the portfolio to make enormous profits. He leveraged the $7.5 billion of investor equity into a $20.5 billion portfolio, to capitalize on these returns. He did this through reverse repurchase agreements; where he pledged his securities as collateral and reinvested the cash in new securities, mostly 5-year notes issued by government-sponsored agencies. His main purpose was to increase current income by capitalizing on the fact that medium-term maturities had higher yields than short-term investments. In 1992, for instance, short-term yields were about 3.7%, while a 5-year yield was around 6%. He increased the duration of the investments to pick up an extra yield, of course with more time comes at greater market risk. By having the portfolio so leveraged this magnified the effect of movements in interest rates. The strategy worked fine as long as interest rates went down. In February 1994, the Federal Reserve Bank started a series of six consecutive interest rate increases, which led to the $1.6 billion loss. This is because bonds have an inverse relationship with interest rates. When the rates go up bond prices go down if they have to be sold prior to maturity. He also started to use a doubling strategy once the portfolios profitability started plunged which caused him to lose greater amounts than he already lost.

The second reason the portfolio suffered catastrophic losses, was citron and the board of directors didn't realize the loss potential or what the overall risk of the portfolio was. Citron took into effect the credit risk, but didn't factor in the market or liquidity risk. Market risk captures the change in an assets value if it is sold prior to maturity. So if they wanted their funds back early they would have to sell them for what the market would bear, and we know that bonds have an inverse relationship



Download as:   txt (5.5 Kb)   pdf (80.4 Kb)   docx (10.5 Kb)  
Continue for 3 more pages »
Only available on OtherPapers.com
Citation Generator

(2011, 12). Orange County. OtherPapers.com. Retrieved 12, 2011, from https://www.otherpapers.com/essay/Orange-County/17711.html

"Orange County" OtherPapers.com. 12 2011. 2011. 12 2011 <https://www.otherpapers.com/essay/Orange-County/17711.html>.

"Orange County." OtherPapers.com. OtherPapers.com, 12 2011. Web. 12 2011. <https://www.otherpapers.com/essay/Orange-County/17711.html>.

"Orange County." OtherPapers.com. 12, 2011. Accessed 12, 2011. https://www.otherpapers.com/essay/Orange-County/17711.html.