Orange County Case

CASO: El CONDADO de ORANGE

1. On what grounds can a case be made that the Orange County bankruptcy was NOT a derivative-related failure? On what grounds can a case be made that it was a derivative-related failure?

We can say it was NOT a derivate-related failure but rather an issue of leverage, bad management, and relatively large holdings of fixed-income securities. Because on 1 December 1994, the day Orange County reported its $1.5 billion unrealized loss, OCIP held no forwards, futures, option, or swap contracts. The portfolio had structured notes ($722.8 million), fixed-income securities ($635.4 million), and reverse repurchase agreements ($67.1 million). Of these three, losses on fixed-income securities and reverse repos were not related to derivatives but rather caused by the rise in market interest rates and the reduction in spreads.

We can say it was derivative-related failure if we consider repurchase agreements to be a form of forward contract but they would account for less than 5% of the total decline in OCIP’s portfolio value.

2. Explain how Robert Citron was able to earn above-average returns when US interest rates fell.

Robert Citron got numerous reverse repurchase agreements betting on declining interest rates. If interest rates fell, Citron gained not only interest returns but also capital gains because the price of the bonds he had to repurchase was fixed at the time of the reverse repo deal. By contrast, the bonds he acquired could be sold at appreciated prices. The combination of falling interest rates plus OCIP’s leverage earned Citron large profits when interest rates fell, but they resulted in large losses when interest rates rose.

3. Explain how reverse repurchase agreements allowed Robert Citron to leverage the OCIP portfolio. Then explain how this leverage led to mammoth OCIP losses.

Reverse repurchase agreements allowed Robert Citron to borrow by selling existing fixed-income assets with the obligation to repurchase them at fixed prices in the future. Using reverse repos, Citron purchased and sold investment assets many times, which increased OCIP’s portfolio so that it had almost three times the assets as it had equity. When losses on these assets rose, the return on OCIP’s equity plummeted.

4. Explain the interaction between Market Risk, Liquidity Risk, and Credit Risk and how this led to the bankruptcy.

The interaction can be explained saying that one risk can trigger another. In this case for example, the raising of interest rates (Market Risk) reduced the market value of OCIP’s portfolio. As a result, the investors tried to withdraw their funds but couldn’t be able to because of the enormous demand for cash which Robert didn’t had (Liquidity risk). This forced Robert to sell assets at reduced prices (Market Risk) and in the end this losses threatened OCIP’s solvency (Credit Risk).