Orange County Essay

After California passed a proposal limiting revenue gene sum upd from local property taxes, pressure was put on local politicss to raise enough money to fund services. Orange County, wish well numerous former(a)s in the US, attempted to raise revenue without increasing taxes. Their treasurer, Robert L. citron tree, trenchant to get involved with a broad(prenominal) riskiness high punish product. He chose to invest in derivatives and gamble with public money. Because interest place were low at the conviction, 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 treasures investments. In 1994, 35% of the countys revenue was from the portfolios returns. The county continued to increase mesh and therefore no one looked into Citrons practices. He did inform the Board of Supervisors that the rate of the countys portfolio depended on interest rates remainin g stable or decreasing. So when interest rates rose, the harbor of the portfolio diminished, eventually leading to bankruptcy. In celestial latitude 1994, Orange County announced a pass of $1. 6 jillion, the to a greater extent(prenominal) or less significant loss recorded by a local government investment pool.This in any case displayed the negative side of the high risk investments do by Citron who was gambling with a $7. 5 billion portfolio make up of players such as cities, school, water works, and regional transportation. 1 There were some(prenominal) factors that led to the bankruptcy of Orange County. A Board of Supervisors member express that there was a lack of oversight (not an accountable system) and failure of manifestation to investors. Citron likewise never met with the investment oversight committee that did exist, and as treasurer he had control over Orange County and their trust.Many be possessed of questioned if Citron was ever qualified to hold his posi tion in office. any(prenominal) even blame the state government. Originally they apply 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 saying that the countys 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 currency would freeze and banks would not be able to liquidate the collateral. Another creditworthy party was Merrill Lynch, the countys financial advisor. The purpose they serve is to protect the interests of the county. They did take to task Citron about the volatility of the investments however they still bought him the same pecuniary resource and underwrote a bond issue for $600 million. The warning was only sent to Citron and not to the Board of Supervis ors. A lawsuit was filed in 1995 against Merrill Lynch by Orange County. 2Besides the power he held over the county, another causa for the bankruptcy was Citrons use of leveraging. As a leveraged fund, it could accept 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 stockh sometime(a)s allow for 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 utilize longer precondition 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 Citrons portfolio depended on interest rates it is a good measure. Because the portfolio utilize median term maturities over short term maturities to increase their return, the age increased. In December 1994 the duration was 2. 74 familys. With the leverage ratio at 2. 73, the demonstrable 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 belittled 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 managers job is to ensure that risks are not interpreted 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 histor ical 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 figure 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. in time 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 leaden moving average can be used to improve the trueness 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 conformation there was the $1. 6 billion in debt that needed to be re-payed to investors. to boot the lawsuit against Merrill Lynch was draining funds from the community with no burnished chance of recovery.The once perfect rating that Orange County held was now downgraded t o 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 detach 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.