Orange County Essay

After California passed a proposition limiting revenue generated from local property taxes, pressure was put on local governments to raise enough money to fund services. Orange County, like many others in the US, attempted to raise revenue without increasing taxes. Their treasurer, Robert L. Citron, decided to get involved with a high risk high reward product. He chose to invest in derivatives and gamble with public money. Because interest rates were low at the time, Citrons portfolio was returning at an average rate of 8. 52%. This was 5% higher than what the state of California was earning. Orange County was enjoying the benefits of their treasure’s investments. In 1994, 35% of the county’s revenue was from the portfolios returns. The county continued to increase earnings and therefore no one looked into Citrons practices. He did inform the Board of Supervisors that the value of the county’s portfolio depended on interest rates remaining stable or decreasing. So when interest rates rose, the value of the portfolio diminished, eventually leading to bankruptcy. In December 1994, Orange County announced a loss of $1. 6 billion, the most significant loss recorded by a local government investment pool. This also displayed the negative side of the high risk investments made by Citron who was gambling with a $7. 5 billion portfolio made up of players such as cities, school, water works, and regional transportation. [1] There were many factors that led to the bankruptcy of Orange County. A Board of Supervisors member stated that there was a lack of oversight (not an accountable system) and failure of disclosure to investors. Citron also never met with the investment oversight committee that did exist, and as treasurer he had control over Orange County and their trust. Many have questioned if Citron was ever qualified to hold his position in office. Some even blame the state government. Originally they used to fund local governments, but when they started taking back they were taking $6. 5 million more than they were giving them. Before the county declared bankruptcy, an investor; First Boston, was selling its collateral because they saw that the county’s portfolio was declining. This was a hint that problems were around the corner because soon many investors would realize this and pull out. In response, bankruptcy was declared so that the funds would freeze and banks would not be able to liquidate the collateral. Another responsible party was Merrill Lynch, the county’s financial advisor. The purpose they serve is to protect the interests of the county. They did warn Citron about the volatility of the investments however they still bought him the same funds and underwrote a bond issue for $600 million. The warning was only sent to Citron and not to the Board of Supervisors. A lawsuit was filed in 1995 against Merrill Lynch by Orange County. [2] Besides the power he held over the county, another reason for the bankruptcy was Citron’s use of leveraging. As a leveraged fund, it could borrow money to increase its securities portfolio. Citron was able to leverage $7. 57 billion into $20. 5 billion. In essence, when the investment produces a high return rate, the stockholders will have a very high rate of return. On the other hand, if the investment produces a low return rate, the stockholders will have a very low return. They also used longer term maturities which makes it more sensitive to changing interest rates. So there is a high leverage risk as well as interest rate risk. [3] Duration is interest rate sensitivity and because Citron’s portfolio depended on interest rates it is a good measure. Because the portfolio used median term maturities over short term maturities to increase their return, the duration increased. In December 1994 the duration was 2. 74 years. With the leverage ratio at 2. 73, the actual portfolio duration was 7. 4 (2. 74*2. 73). When the interest rates rose in 1994, the estimated loss using duration was $1. 85 million, a little more than the actual amount. interest rates went up about 3. 5 and 5 year bond yield was 5%) VaR could also have been used to find some risks of the portfolio. VaR is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. The risk manager’s job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome. investopedia definition) The portfolio was sensitive to interest rates so a change in the rate can be used in 3 simulation methods and the only impactive factor. Using a historical simulation approach, the VaR equals $1. 24 billion. This is lower then the actual value but it is also using past prices to determine the future. In the delta normal method VaR is calculated as $1. 21 billion. This is a little less accurate then the historical method. The best way in theory to calculate Var would be using the Monte Carlo Simulation. However in this situation it treats the portfolio as one asset and equals about $1 billion. Because none of these prove to be reliable enough, a exponentially weighted moving average can be used to improve the accuracy of VaR. What it does it give more weight to recent data then older data. [4] As a result of the bankruptcy many unfortunate consequences arose. Of course there was the $1. 6 billion in debt that needed to be re-payed to investors. Additionally the lawsuit against Merrill Lynch was draining funds from the community with no promising chance of recovery. The once perfect rating that Orange County held was now downgraded to a default rating by Standard & Poor. There were also many political consequences regarding the county and county officials. If the risk of the portfolio was taken into consideration by the appropriate parties, the entire situation could have been avoided. Unfortunately the power to stop Citron was in the hands of Merrill Lynch who did not take the appropriate action. The County also failed to monitor and assess the deal which puts several more people at blame for the bankruptcy.