Philippe Jorion's

Orange County Case:

Using Value at Risk
to Control Financial Risk

Summary
The 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.
This Web case can be used by academic institutions free of charge;
other users should contact Professor Jorion.
The case is also subject to continuous improvements.
© 2009- Philippe Jorion

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.
(1) Introduction
In 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?

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(2) The Portfolio

In 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. 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.

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(3) Value at Risk

What 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.

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. For 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. For links to risk management sites, visit the following address:
Barry Schachter.

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(4) Questions
Let us place ourselves in the position of the county Supervisors, who had to decide
in December of 1994 whether to liquidate the portfolio or maintain the strategy
(obviously, based on past information only). At that time, interest rates were still on
an upward path. A Federal Open Market Committee meeting was looming on
December 20, and it was feared that the Fed would raise rates further. To assess
the possibility of future gains and losses, VAR provides a simple measure of risk in
terms that anybody can understand--dollars.

(1) Duration approximation.

The effective duration of the pool was reported by the state auditor as 7.4 years in
December 1994. This high duration is the result of two factors: the average
duration of individual securities of 2.74 years (most of the securities had a maturity
below 5 years), and the leverage of the portfolio, which was 2.7 at the time. In
1994, interest rates went up by about 3%. Compute the loss predicted by the
duration approximation and compare your result with the actual loss of $1.64
billion.

(2) Computation of portfolio VAR.

(2) The yields data file contains 5-year yields from 1953 to 1994. Using this
information and the duration approximation, compute the portfolio VAR as of
December 1994. Risk should be measured over a month at the 95% level. Report
the distribution and compute the VAR:
- using a normal distribution for yield changes (Delta-Normal method), and
- using the actual distribution for yield changes (Historical-Simulation method).
Compare the VAR obtained using the two methods.
Download the "yields.xls" file.

(3) Interpretation of VAR.

- Convert the monthly VAR into an annual figure. Is the latter number consistent
with the $1.6 billion loss?
- From December 1994 to December 1995, interest rates fell from 7.8% to 5.25%.
Compute the probability of such an event.
- It seems that both in 1994 and 1995, interest rate swings were particularly large
relative to the historical distribution. Suggest two interpretations for this
observation.

Advanced (1)
Compute a time-varying volatility of changes in yields using the RiskMetrics approach to see if the
recent volatility is abnormally high. The exponential model (as used in Riskmetrics) is:

Var[dy(t)] = Var[dy(t-1)] * k + [dy(t-1)*dy(t-1)]*(1-k)

where Var[dy(t)] is the "conditional," predicted variance for time t and k is the "decay" factor, usually
selected as 0.97 for monthly data. The model states that the variance forecast is a combination of
the previous month forecast and of the latest squared innovation. For the starting value of the
variance (at time t=0), use the average variance over the whole period.
Compute the monthly volatility forecast (the square root of Var[dy(t)]) and discuss whether recent
interest rates swings are explained by elevated volatility.

Advanced (2)
Next, we check whether the assumption of a conditional normal distribution seems adequate for
changes in yields. Compute the number of exceptions at the 1-tailed 95% level, using the monthly
volatility forecast just computed and the actual increase in yield. Test whether the number of
exceptions is in line with what was expected.
(For the exception test, you can use the normal approximation to the binomial distribution. Also, be
careful to match the volatility forecast with the subsequent change in yield.)

Really Advanced (Optional)

The historical simulation approach assumes that changes in monthly yields have an independent,
identical distribution (i.i.d.) The issue is whether this assumption is appropriate:
- Consider now a model with mean-reversion in the mean, such as the Vasicek model (if seen in the
fixed-income course). Estimate the model, test whether mean reversion seems significant, and
evaluate VAR in the context of this new model. Does monthly VAR change? What about annual
VAR?
- Estimate a GARCH model for the change in yield and compare the forecasts to that of the EWMA
model.

(4) Hedging.
- On December 31, 1994, the portfolio manager decides not to liquidate the
portfolio, but simply to hedge its interest rate exposure. Develop a strategy for
hedging the portfolio, using (i) interest rate futures, (ii) interest rate swaps, and (iii)
interest rate caps or floors. For each strategy, describe the instrument and whether
you should take a long or short position.
- On that day, the March T-bond futures contract closed at 99-05. The contract has
notional amount of $100,000. Its duration duration can be measured by that of the
Cheapest-To-Deliver (CTD) bond, which is assumed to be 9.2 years. Compute the
number of contracts to buy or sell to hedge the Orange County portfolio.
- This contract has typical trading volume of 300,000-400,000 contracts daily.
Verify with recent volume data at the Chicago Board of Trade (CBOT). Would it
have been possible to put a hedge in place in one day?
- Assuming that futures can be sold in the required amount, would the resulting
portfolio be totally riskless?

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(5) Epilogue
By liquidating the pool in December 1994, the county locked in a loss of $1.6
billion. Unfortunately, soon after the liquidation, interest rates went back down by
about 2.5 percent. One does not need a rocket scientist to realize that the
liquidation entailed a huge opportunity loss, on the order of $1.4 billion. This
opportunity loss, however, is in hindsight. Very few market observers expected
interest rates to go down so fast in 1995. The Orange County Business Journal
recently ran a story, County's Timing Was Oh So Bad, based on my graph. Plot the
pool's hypothetical loss (Figure 4).

The county, fortunately, fared much better than had been feared. Disaster was
narrowly avoided as schools were paid back just enough to avoid default; the
county was able to extend its debt over 20 years. Perhaps the greatest help came
from the private sector, in the form of a booming economy leading to greater sales
tax receipts and payments by the State.

Since then, the county has filed a recovery plan centered on a $800 million bond
issue, in which creditors would be fully repaid. Some county expenses were cut, or
transferred to other agencies. Investors in the pool (cities, schools, agencies and
the county itself), however, are still facing a $800 million shortfall.

It is unlikely the $1.6 billion loss will ever be recovered. So far, the county has
settled a $2 billion lawsuit against Merrill Lynch, its principal broker, for $437
million. (Incidentally, this number is very close to the fall in the market value of
Merrill stock on the day the bankruptcy was announced.) The county has
recovered so far $650 million, a far cry from the $1.6 billion loss.
Show update on lawsuits

Visit the Merrill Lynch home page and the press release.

The municipal bond market was also badly hit by the bankruptcy. Municipal
investments, who were supposed to be guaranteed by the ``full faith and credit'' of
the issuer, suddenly appeared vulnerable to default. Munis generally dropped in
price relative to Treasuries, which in effect raises the cost of capital for all
municipalities around the country.

Additional lessons can be learned from this exercise. Had value at risk been
measured before 1994, the Orange County fiasco could very well have been
avoided. It is fair to say that, had the Treasurer announced that there was a 5
percent chance of losing more than $1.1 billion over a year, many investors would
have thought twice about rushing into the pool. In addition, investors would not
have the excuse that they did not know what they were getting into, which would
have limited the rash of ensuing lawsuits.

John Moorlach, the new Treasurer until 2006, has instituted new investment
policies for the investment pool. Thereafter, Moorlach was elected to the Board of
Supervisors. Chriss Street became Orange County's Treasurer.

Visit the Orange County home page

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References

Read the full account of the Orange County disaster,

Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County,
published by Academic Press (September 1995).

In response to billion-dollar losses (Orange County, Barings, Daiwa,

Metallgesellschaft...), the financial industry is turning to Value at Risk
(VAR) as a method to control market risks.

Professor Jorion wrote the first book on VAR

Value at Risk: The New Benchmark for Controlling Market Risk,
published by Irwin Professional (July 1996). The book has been translated into
Chinese, Hungarian, Japanese, Korean, Polish, Portuguese, and Spanish. It has
been called an "industry standard".
A new edition was published in 2006.

To learn more about risk management, read the Financial Risk

Manager (FRM) Handbook. This is the official book for the FRM
examination organized by the Global Association of Risk
Professionals (GARP). This Handbook provides the core body of
knowledge for financial risk managers.
A new edition is published by Wiley in 2009.
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