The Orange County Investment Pool Loss (1994)

For risk management and internal audit staff, the Orange County case shows, through the auditor's report, how investment principles and the size of borrowing affected the loss.

What happened

The treasurer of Orange County, California, managed the county's funds, together with the funds of about 190 public agencies such as cities, special districts, and school districts, in a single shared investment pool. As of November 30, 1994, the treasurer's portfolio totaled USD 20.6 billion¹.

On December 1, 1994, the county announced that its portfolio had incurred paper losses of about USD 1.5 billion. A paper loss is the difference between the acquisition price of an investment and its market value, and it is not final until the investment is sold. On December 6, the county's board of supervisors filed for protection under Chapter 9 of the U.S. Bankruptcy Code (the reorganization procedure for local governments) on behalf of the county and the pool's participants. One reason for the filing was that investment banks declined to renew or renegotiate the county's borrowing under repurchase agreements (transactions in which funds are borrowed against securities)². The loss was first estimated at USD 2.02 billion and was revised in January 1995 to USD 1.69 billion³.

What the pool held and how events unfolded

The investment experts hired by the state auditor found that the pool had raised its yield in two ways. The first was to borrow funds against the securities it held (in the report, reverse repurchase agreements) and use the proceeds to buy more securities.

If the securities bought with the borrowed funds paid a higher rate than the borrowing cost, the difference was income. But when interest rates rose in 1994, borrowing costs increased and the value of the securities bought fell, so this approach stopped working. The second way was to hold high-risk securities with long maturities that paid off as long as interest rates did not rise⁴.

On November 30, 1994, the participants' original investment (the base portfolio) was USD 7.6 billion, and the portfolio totaled USD 20.6 billion. Of this, USD 13 billion was bought with funds borrowed through repo transactions. Dividing USD 20.6 billion by USD 7.6 billion gives about 2.7 times, so the effect of interest rate changes was also amplified 2.7 times⁵.

At least USD 6.6 billion (32%) of the portfolio was in inverse floaters, a type of structured note. The interest rate on an inverse floater falls when the benchmark rate rises. In the report's example, the rate is "9 percent, less the six-month LIBOR" (LIBOR is one benchmark rate). In the same example, if LIBOR is 3% the rate is 6%, and if it rises to 5% the rate falls to 4%. Because a rise in rates lowers the coupon and the value, this was a position betting that interest rates would stay low or fall. Together with other structured notes, they exceeded 40% of the portfolio⁶.

What the report identified as the causes

The state auditor's report stated that the principles for investing public funds should rank safety, liquidity, and yield in that order, and concluded that the county pool reversed this order and put yield first⁹. Inverse floaters lose value when rates rise, so when rates rose sharply in 1994, the portfolio lost a large share of its value. The auditor's experts said they found no significant evidence of transactions that offset the inverse floater positions (hedges)¹⁰.

The experts found that from June 1991 to June 1994, the combination of longer maturities, borrowing, and structured notes more than tripled the base portfolio's vulnerability to rising interest rates. Vulnerability here means how much the portfolio's value falls when rates rise. As of November 30, 1994, the base portfolio was in a position where a rise of just 1% in rates would cause a loss of USD 560 million¹¹.

The auditor's recommendations

The auditor recommended, among other things, that the county create a comprehensive investment policy. Some of the items it asked to be included in the policy are as follows¹².

• Limits on repo borrowing
• Limits on purchases of derivatives and structured notes
• An investment advisory committee independent of the treasurer
• Quarterly reports

To the state legislature, it recommended, among other things, the following¹².

• Require local governments to put their investment policies in writing
• Limit repo borrowing to 20% of the portfolio
• Limit purchases of derivatives and structured notes
• Prohibit the issuing of bonds for speculation or risk arbitrage

The county replied that it generally agreed with the report's findings and recommendations¹².

Whether the recommendations were carried out, and how state law was actually amended, is not covered on this page.

Notes

1. Report of the California State Auditor, "Orange County: Treasurer's Investment Strategy Was Excessively Risky and Violated the Public Trust" (March 1995; hereafter, the auditor's report), PDF pp. 7–8. ↩

2. The auditor's report, PDF pp. 9–10 (the "Filing for Bankruptcy Protection" section). ↩ ↩² ↩³ ↩⁴

3. The auditor's report, PDF pp. 10–11. ↩ ↩²

4. The auditor's report, PDF pp. 16 and 19 (the difference between the rate on securities bought with borrowed funds and the borrowing rate is called the "spread"). ↩

5. The auditor's report, PDF p. 19 (the section "The Overall Portfolio Was Highly Leveraged"). ↩

6. The auditor's report, PDF pp. 27, 28, and 31. The example of an inverse floater rate is on p. 27. ↩

7. The auditor's report, PDF p. 8, Table 1. ↩ ↩²

8. The auditor's report, PDF p. 70 (the date of the auditor's signature). ↩

9. The auditor's report, PDF pp. 15–16 (the "Basic Principles of Prudent Investment Practices" section). ↩

10. The auditor's report, PDF p. 28. ↩

11. The auditor's report, PDF pp. 31–32. ↩

12. The auditor's report, PDF pp. 4–5 ("Recommendations" and "Agency Comments"). ↩ ↩² ↩³