Question

Orange County Bankruptcy case 1994

How the Fed action affects the interest rate in 1994?

Describe the crisis following the Fed action

Describe the outcomes?

Answer 1

Orange County Municipality was one of the richest being located in California state. It had good track record which was consistently providing good returns by beating the benchmark till the year 1994, thanks to its portfolio manager Bob Citron. He was entrusted as a treasurer to manage a pool of $7.5 billion, which consisted of mostly county schools, special districts and the county itself. It earned a good reputation.

But it stunned the markets when it filed for Bankruptcy which resulted in losses of $1.6 billion. The strategy of the portfolio was, the equity amount of $7.5 billion was used for Reverse Repurchase Agreements. In which the fund pledged the Securities for cash. Now this cash used to buy 5 year medium-term bonds whose interest rates were higher than short-term bonds. It was betting on the fact that the long-term interest rates will be lower for a foreseeable future. But Fed's decision on interest rates hike for consecutive six periods resulted in failure of the strategy. Also there was lot of leveraged created due to usage of Reverse Purchase Agreements. This negative movement amplified the losses. The outcome of Fed decisions resulted in failure of Portfolio Strategy. This also led to huge losses to investors, Bob Citron also resigned from the post of Treasurer which he previously held for 24 years.

To get into little more details of this particular bankruptcy case, the amount which Bob got from Reverse Repurchase Agreements were particular used as leverage (Leverage at it means taking more exposure than what you can actually) to buy or invest in $20 billion medium-term bond securities which were Floating Rate Notes (FRN). So because these FRNs have the interest rate floating, so they change according to change of interest rates in market. When Fed started hiking the interest rates, it just got too bad for Bob as the strategy which he thought that interest rates will stay low in the foreseeable future turned out to be wrong. Now due to increased leverage on the FRNs the losses were also high due to floating interest rates as the risk is higher. One important concept of bonds is that the interest rate and bond values move in opposite direction. So as the interest rates increase the bond values fall and vice-versa.