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Orange County

Key Object: Orange County Investment Pool. Short term high liquidity fund for countyPlayersCities Schools Water worksRegional transportationBalance revenues and expenditures?Cash management". Typical Local Government Pooled Funds. Low risk objectsT-bills and bondsLow risk commercial paperV

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Orange County

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    1. Orange County Fin285a: Lecture 5.1b Fall 2010 Readings: Marthinsen, chapter 6

    2. Key Object: Orange County Investment Pool Short term high liquidity fund for county Players Cities Schools Water works Regional transportation Balance revenues and expenditures “Cash management”

    3. Typical Local Government Pooled Funds Low risk objects T-bills and bonds Low risk commercial paper Very high rated corporate bonds Basic properties Low default risk High liquidity Low returns

    4. Basic Risk Factors Credit risk (default) Market risk (interest rate and price changes) Liquidity risk (ability to sell portfolio) Cash flow squeezes

    5. Key Player: Robert Citron Starts working for county: 1960 1970: tax collector 1973: tax collector and treasurer Performance (12 years prior to 1994) 7.8% California pool 4.2%

    6. Supervision/Oversight Orange county board of supervisors Popularly elected Little formal training for either Citron or board in finance Citron challenged in 1994 in election John Moorlach “This listing is junk” Campaigned on theme that portfolio was too risky Lost

    7. Budgetary Issues Proposition 13 Tax payer revolt on local property taxes

    8. Orange County Portfolio Assets ($20.5 billion) Structured notes (40%) Inverse floating-rate notes (26.1%) Fixed-income securities (58%)

    9. Inverse Floating Rate Notes Interest = 8% - Libor Interest payments move inversely with market interest rates

    10. Orange County Portfolio Liabilities $13 billion Reverse repurchase agreements Investor equity $7.5 billion

    11. Repurchase Agreements Today Customer sells security (bond) to dealer for 100 Future Customer repurchases security for 103 from dealer Fixed interest payment

    12. Repurchase Agreements P = y/(1+r) Repurchase amount fixed Case: r falls P rises, and the value of the repurchased bonds increase (gain) Case: r rises P falls, and the value of the repurchased bonds decreases (loss)

    13. Term Structure Effects Citron also used repurchase agreements to borrow at the short end of the term structure, and lend at the long end As long as this spread was positive and large enough things worked well

    14. Portfolio Sensitivity Two objects that move inversely with interest rates Inverse floaters Repurchase agreements Leverage magnification

    15. US Interest Rates Falling 89-93 Rising: 94 Orange county in trouble Citron extends positions (doubling) Investors pull funds out

    16. Bankruptcy: Dec 1994 County declares bankruptcy Liquidate portfolio (loss = 1.4 billion)

    17. Post Analysis Were derivatives to blame? Was Orange county bankrupt? Assets-liabilities = 6.1 billion in 1994 Was Orange county illiquid? Was it a mistake to liquidate the portfolio? Interest rates peak in Dec 1994

    18. Big Picture Single investor makes unusual interest bets No one (maybe not even he) understands these Could this be prevented?

    19. Case for VaR Jorion estimates 95% confidence VaR at 1.1 billion Very high for near zero risk portfolio (equity about 7 billion) Could this number have been used to explain risks to supervisors???

    20. Lessons Better risk measures and oversight Credit risk not enough Liquidity risk matters Scrutinize risk/return anomalies Too good to be true

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