Orange County, 1994

At a glance

What happened

Orange County ran a pooled fund for itself and roughly two hundred schools, cities and districts. The securities were high quality, mostly agency paper, but the pool borrowed against them through repurchase agreements until it held about $20bn of securities on around $7.5bn of deposits. Much of what it bought also had leverage written into the coupon. When US rates rose through 1994 the portfolio lost about $1.7bn, lenders demanded more collateral, and in December the county filed for bankruptcy, then the largest municipal failure in US history.

Why it went wrong

There were two layers of leverage, and rising rates hit both. Repo multiplied every price move by nearly three. Inverse floaters, whose coupons fall as short rates rise, behave like much longer bonds than their maturity suggests. As prices fell the repo lenders called for collateral, forcing sales into a falling market. And because the pool reported at book value rather than market value, the depositors had no warning until it was too late.

What it teaches

Credit quality and market risk are separate questions: a portfolio of safe issuers can still be a highly risky position once it is leveraged. Leverage hidden inside a coupon formula will not show up in any measure that only counts borrowing. Public funds now face leverage limits, maturity limits and mark-to-market reporting because of this case.

Key terms

Repurchase agreement

Selling a security for cash with an agreement to buy it back, the standard way to borrow against bonds.

Inverse floater

A note whose coupon falls as a benchmark rate rises, giving it far more interest rate risk than its maturity suggests.

Effective duration

The true price sensitivity of a structured note to rates, which can be several times its stated maturity.

Collateral call

A repo lender’s demand for more security as the collateral falls, met by selling into the same fall.

Book value reporting

Reporting holdings at cost rather than market, which conceals a loss until it must be realised.

Investment pool

A shared fund holding cash for several public bodies, whose participants here could not see the risk taken.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of leverage and interest rate risk; collateral calls. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

Related case studies

• The gilt LDI crisis, 2022Pension hedges that worked, and could not be funded

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Interest Rate SwapTrade fixed for floating payments
• Cap and FloorSet a ceiling or floor on a floating rate