Orange County Case

Orange County Case

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?

1. We can say it wasn’t a derivative-related failure because on December 1st, which was when Orange County first reported the $1.5 billion loss; OCIP didn’t have any type of derivatives. Their portfolio was made up of fixed-income, structured notes, and reverse repurchase agreements. The losses that OCIP encountered were caused by the rise in interest rates and the reduction in spreads, which lead to losses in fixed-income securities and reverse repurchase agreements.  
2. The only reason I see that it could be called a derivative-related failure is if you consider repurchase agreements as a form of derivative and that still wouldn’t be a good argument because their weight in the portfolio wasn’t a lot.

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

1. With the repos, Citron was able to use the securities as collateral for loans in order to buy more securities. This method almost tripled his portfolio position. While the massive leveraging amplified his gains, his prediction on interest rate declines came true. The interest rate decline helped Citron because that meant that his yield spread would be larger and therefore he would have better returns. With this situation, Citron was able to not only have have better returns but it also meant that he would have capital gains because the price of the bonds he had to repurchase was fixed at the time of the reverse repo deal and the bonds he acquired could be sold at appreciated prices. The combination of falling interest rates and OCIP’s leverage meant large profits when interest rates fell.

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

1. A reverse repurchase agreement is a deal in which the owner of a security uses it as collateral to borrow money and then invests the borrowed money in another security.
2. Reverse repurchase agreements allowed Robert Citron to borrow by selling existing fixed-income assets. 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.
3. In times of declining or stable interest rates, the strategy is a great money maker because it increases the yield spread, but when interest rates rise the money borrowed becomes more expensive and the securities purchased lose value. This basically reduces investment gains and the value of the collateral declines.

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

1. These three risks normally have a domino effect on each other; once one starts to occur, the next will probably follow. That is exactly what happened in this case.

1. Market risk:

1. The rising interest rates reduced the market value of OCIP's portfolio.
2. Citron was forced to sell assets at reduced prices.

1. Liquidity risk:

1. Investors tried to withdraw their funds, creating demand for cash.

1. Credit risk:

1. OCIP’s solvency was put at risk because of their inability to pay their debt.
2. OCIP’s insolvency lead to bankruptcy.

1. According to your judgment, what are the main lessons learned from the bankruptcy of Orange County.

1. Past performances or returns DO NOT guarantee future success or returns. You have to adjust and modify strategies.
2. Investing defensively and diversifying is extremely important (the majority of OCPI’s portfolio was fixed-income).
3. Stubbornness has no place in finance. Citron didn’t take into account the early signs that interest rates would rise because he was so rigid in his belief that interest rates would fall. He also didn’t take a defensive position once they did start to rise.
4. You can’t gamble (speculate), especially with so much leverage. Citron increased the portfolio three times its original size all on a speculation that the interest rates would fall.

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