SummaryThe purpose of this case is to explain how a municipality can lose $1.6 billion in financial markets. The case also introduces the concept of "Value at Risk" (VAR), which is a simple method to express the risk of a portfolio. After the string of recent derivatives disasters, financial institutions, end-users, regulators, and central bankers are now turning to VAR as a method to foster stability in financial markets. The case illustrates how VAR could have been applied to the Orange County portfolio to warn investors of the risks they were incurring.


Content(1) Introduction
(2) The Portfolio
Describes the portfolio composition, leverage, and risk exposure.
(3) Value At Risk
Introduces VAR as a method to control risk.
(4) Questions
Shows how VAR could have been applied to the OC portfolio.
(5) Epilogue
Discusses the recovery of Orange County and the impact of the bankruptcy on financial markets.
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(1) IntroductionIn December 1994, Orange County stunned the markets by announcing that its investment pool had suffered a loss of $1.6 billion. This was the largest loss ever recorded by a local government investment pool, and led to the bankruptcy of the county shortly thereafter.
This loss was the result of unsupervised investment activity of Bob Citron, the County Treasurer, who was entrusted with a $7.5 billion portfolio belonging to county schools, cities, special districts and the county itself. In times of fiscal restraints, Citron was viewed as a wizard who could painlessly deliver greater returns to investors. Indeed, Citron delivered returns about 2% higher than the comparable State pool. Plot Citron's track record (Figure 1). Citron was able to increase returns on the pool by investing in derivatives securities and leveraging the portfolio to the hilt. The pool was in such demand due to its track record that Citron had to turn down investments by agencies outside Orange County. Some local school districts and cities even issued short-term taxable notes to reinvest in the pool (thereby increasing their leverage even further). This was in spite of repeated public warnings, notably by John Moorlach, who ran for Treasurer in 1994, that the pool was too risky. Unfortunately, he was widely ignored and Bob Citron was re-elected. The investment strategy worked excellently until 1994, when the Fed started a series of interest rate hikes that caused severe losses to the pool. Initially, this was announced as a ``paper'' loss. Shortly thereafter, the county declared bankruptcy and decided to liquidate the portfolio, thereby realizing the paper loss. How could this disaster have been avoided?
(2) The PortfolioIn fact, Bob Citron was implementing a big bet that interest rates would fall or stay low. The $7.5 billion of investor equity was leveraged into a $20.5 billion portfolio. Through reverse repurchase agreements, Citron pledged his securities as collateral and reinvested the cash in new securities, mostly 5-year notes issued by government-sponsored agencies. One such agency is the Federal National Mortgage Association, affectionately known as ``Fannie Mae''.
The portfolio leverage magnified the effect of movements in interest rates. This interest rate sensitivity is also known as duration. [url=http://merage.uci.edu/~jorion/oc/case2.html]2.1 Define duration The duration was further amplified by the use of structured notes. These are securities whose coupon, instead of being fixed, evolves according to some pre-specified formula. These notes, also called derivatives, were initially blamed for the loss but were in fact consistent with the overall strategy. Citron's main purpose was to increase current income by exploiting the fact that medium-term maturities had higher yields than short-term investments. On December 1993, for instance, short-term yields were less than 3%, while 5-year yields were around 5.2%. With such a positively sloped term structure of interest rates, the tendency may be to increase the duration of the investment to pick up an extra yield. This boost, of course, comes at the expense of greater risk. Plot the term structure on December 1993 (Figure 2). Display term structure of interest rates as of last week: Bloomberg. The strategy worked fine as long as interest rates went down. In February 1994, however, the Federal Reserve Bank started a series of six consecutive interest rate increases, which led to a bloodbath in the bond market. The large duration led to a $1.6 billion loss. Plot the path of interest rates to December 1994 (Figure 3). Graph interest rates: Federal Funds. [/url]
(3) Value at RiskWhat is VAR? VAR is a method of assessing risk that uses standard statistical techniques routinely used in other technical fields. Formally,

VAR is the maximum loss over a target horizon such that there is a low, prespecified probability that the actual loss will be larger.

Based on firm scientific foundations, VAR provides users with a summary measure of market risk. For instance, a bank might say that the daily VAR of its trading portfolio is $35 million at the 99% confidence level. In other words, there is only one chance in a hundred, under normal market conditions, for a loss greater than $35 million to occur.
This single number summarizes the bank's exposure to market risk as well as the probability of an adverse move. As importantly, it measures risk using the same units as the bank's bottom line---dollars. Shareholders and managers can then decide whether they feel comfortable with this level of risk. If the answer is no, the process that led to the computation of VAR can be used to decide where to trim risk. 3.1 Introduction to VAR 3.2 Methods to measure VAR 3.3 Duration and VAR No doubt this is why regulators and industry groups are now advocating the use of VAR systems. Bank regulators, such as the Basle Committee on Banking Supervision, the U.S. Federal Reserve, and regulators in the European Union such as Britain's Financial Supervisory Authority have converged on VAR as an acceptable risk measure. The Securities and Exchange Commission has issued a new rule to enhance the disclosure of market risk. The rule requires publicly traded U.S. corporation to disclose information about derivatives activity using a VAR measure as one of three possible methods.
See the text of the European Capital Adequacy Directive (98/31/EC) which allows the use of VAR-based internal models. <! and proposals for
Other Sites with VAR Information Perhaps the most notable of private-sector initiatives toward better risk management is that of J.P. Morgan, which unveiled its RiskMetrics system in October 1994. Forecasts of risk and correlations for more than 400 assets are posted daily on the RiskMetrics site (now with a six-month lag for free data). The RiskMetrics database allows users to compute a portfolio VAR using the Delta-Normal method based on a 95% confidence level over a daily or monthly horizon. There is a growing army of vendors who provide software ranging from Excel add-ons to million-dollar firm-wide risk management systems. <! third party vendorsFor instance, visit the sites of Algorithmics , BARRA Risk Management, Sungard Trading and Risk Systems.
Among consultants, Capital Market Risk Advisors are well known. The New York consulting firm was hired November 3, 1994, to dissect the Orange County portfolio. Within a week, CMRA warned the county that the pool had already lost $1.5 billion. The firm now specializes in the valuation of complex portfolios, and in "financial forensics"--analyzing sources of financial losses.
There is even an association of risk management professionals, the Global Association of Risk Professionals, which provides a forum for the exchange of information and education in the area of financial risk management. GARP administers the "Financial Risk Manager" certification upon successful completion of an examination.