Describe and evaluate the financial risk management process shown in the case study. (350 word)

SUNGARD BANCWARE ERISK An ERisk.com Case Study Orange County December 6 1994 Orange County.pro perous district in Coll a declared to Tuloy or suffering loss o around $16 billion from a wrong way beton Interested in one of i principal investment pool. The pool was intended to be a con votive but profitable way of man nging the county cows, and those of 241 nociated ocal gov omment on todo gered the largest financial four of a local government hus hory Robert Ciron the West widely pected Orange County treo urer who controlled the 57.5 bilion pool hodily invested the pools fundino leveraged portfolio mainly interest-linked sites strategy depended on short.com Werest rates remaining lovely bow when compared with medium Term Interest roles. But from February 1994 the Federal Reserve Bonk begon to US interest ales couing many south Orange County's Vivestment pool to folin value During much of 1994 Citron gnored the shin is the interest rate evronment and the mounting "popier losses in his portfoloBut by the end of 1994, demand forbi fons of dolors of colateral from Citron's Wol Sheet counterparties and the threat of a non depot som spooked local government Investor created a liquidity trop that he could not scope Chron could not have under taken such as investment strat egy his actions had been subject to Informed and independentisk overnight and detailed ravene Investment guidelines Following of the rules stounding how funch the debacle. Orange County could be veled. In addition to revied many aspect of its conto the county het municipalities procedures and in froncial gove such as the Orange County cities of nonce, and shed orice Anaheim and wong with or set of investment policies lous local government authorities and services were attached to the The story investment pool by the unusvaly Orange County treasuror Robert good rates of return it offered. Citron was no new lid on the block These veston put money that He had been resince 1972 they rahed from and other and in early 1994. at about the time sources into the pool in the hope his hvement strategy began to that the cath would grow before go tour he survived on election they had to spend on vital public that focused public ottention on services. Excurfume from the financial management of the pool were particularly welcome in Orange County Investment pool the early 1990 the local political Chron monoged to convince vot: environment was so agorring es that the criticism, which fumed taxes and local government out to be close to the more were finances were under in creating policly motivated strain some municipal entities oven Chron's strongest cord wat begon to borrow money to track record Earnings from the increase the pool investments investment pool had been an According to some commento Increasingly important part of the for the excem relut over the Orange County budget since the year amounted to hundreds of te 1970L leading to a relation tons of doon and in imited Lessons lemod leware the uncontroined to performer, even when he or she has a fora track record. Where theres excess wordthere's not though it might ke time to surface the organisational structure planning and saveigh mechanisme of an intitution are tractured the easy for powerful dvduan to hide risk in the gap lorowing short and Investing long meant foudy skot every bank ROWE vesse estos most investment objectives to investment action by means of a homework of investment policies guidelines reporting and independent and expert oversight Preparing should be complete and only comprensible to Independent profesional Strategies that are not posible to explain to Inled parties should not be employed by the risk overse BE.COM ERisk.com sense considerably offset the bearing sculties would maintain eventual loss or increase their voice. He used van few municipal investon in the lous techniques to leverage ha $25 pool quizzed citron on how he billion of funds into more than 520 worked his magic or analysed billion of investments so that both independently the level of khe thereums and the risks were molts was running to gain excess returns pled. They took comfort from the fact One way he did this was to enter that Orange County was sell into contracts nown as revese heory wested in the pool repurchase agreements which However, the board of super allowed him to be securities the son that acted as the principal pool had already purchased as oversight for Cihan's actions as colateral on further bonowings Orange County Treasurer locked and further cycles of investing. But financial sophistication. Orange these agreements et im vunero County also failed to surround ble to calls for more collect the Citron with a compensating into market value of the original coll structure of strict investment poli oral fell cies, rok control regular and detoled reporting and independ ent oversight this mattered more Citron used various and more as the aim of the pool techniques to leverage his gradually tuned towards moking rather than managing, money. 87.5 billion of funds into Through the worly 1990s. Citron more than $20 billion of enjoyed his growing importance os someone who conjured up extra investments so that both money for public services. The the returns and the risks amount of public money in the pool grew quickly unin 1994 were multiplied Chion was investing $7.5 billion in US agency notes of various kinds. He woso popular port of cal forces Citron cho used around $2.81 mon from Wal Street's big broker: Ron of structurednotetor de og firm particulary those tromve to increase this bet on the securities giant Merrill Lynch Later structure of the interest rate yield these stesmen would say they curve. These included many were merely servicing an expen inverse footer-notes whose enced and savvy investor while coupon fat as interest ratesi Citron would com he had been as well as index amorting notes med about the lines of the and collected mortgage cob instruments golons One thing is certains while the The relative complexity of the pool offered greater returns than instruments the cosy chain struc those of similar coth management ture of the portfolio and Citros pool, did so only by taking on to financial reporting made it more risk. In particule Changomficult for independent critics to bied that medium-term interest understand o prove how the Timeline of events February 199 Fed makes the fint of a series of interest rate hikes and so threatens the drectional bet on interest rates built into the Orange County investment pool September 1994 Orange County treat Robert Ciron tries to com growing fears among investors November 1994 Auditors find that the pool nos massively lost value. December 1, 1994 Chon confirms that the poor faces 51.5 bilion loss December 3. 1994 Cironmenigw. December 6, 1994: Prompted by due date of certain repo transactions Orange Country Miles for Chapter protection May 2. 1995: US Boluptcy Cout endoset settlement of what is left in the investment pool. Some 24 participants get 77 cents in each dolor of their investment balance as a corbution November 19.1994 Cloni sentenced to a year in oond $100.000 line December 17, 1997: Moody's investors Service towards the county's recovery and new investment policies with on Investment grade rating for key county bomowings June 2. 1918 Orange County rooches $400 million settement of sawsuit against Memilynch February 25, 2000. Some 200 municipal and governmental agencies finally made good in disbursement of $864 milion Hut Orange County continues to DGY off the recovery bonds issued in 1995/4 to find the bulk of the pool's lowes. une 2001 02 ERisk.com strategy oly was. But the end That agrooment provod elusive result is clear the pool transformed and Wall Street institutions began to short-term funds intended for vital eloll the securities they held al public services into a risky and colateral against the agreements leveraged Investment in medium with Orange County. The Orange term francial Instruments County Board of Supervisors took As long as short-term interest legal advice and declared bank rates remained low, as they did in ruptcy on December 6, a move the early 1990s, Citron's bet on the that prevented investors withdraw relative value of medium terming any more of the funds. It also interest rate linked securities paid set the scene for a public auction off and all concemed prospered. of Citron's investment portfolo so The strategy soured with a shift in that the proceeds could be rein policy by the Federal Reserve invested in safe and liquid that February 1994. That month saw the doled government stock First of a succession of hikes in inter By January 19, with this restructure estrates that ultimately saw the Feding completed Orange County's Citron exposed a set of conservative investors with specific funding needs to a risky portfolio. He failed to communicate the extent of the market risk, or liquidity risk, to either the investors or to his supervisory board though he did not hide the fundamentals of his strategy attracted risk avoro funds in the first place. But it is wrong to blame one individual. Thesisk managers of Canadian Investment bant CIBC recently compared the Orange County falute to that of Songs Bank pointing out that in these ott erwise very different debacles, the man in charge showed excelent results at first, and was therefore alowed to transact without proper surveillance or control" (Crouhy et ok. 2001. Orange County is primo tily a story of what happens when the desire for excess returns over rides rikvenight The aftermath Citron eventually pleaded guilly to six felony counts. However, the charges were largely to do with a mitolocation of returns between the county and other municipal entities and Citron does not sem to have been motivated by per sonal gain of any direct and obv ous kind. He paid a $100,000 fine and spent less than a year under house rest If that seems lenient lentence then Orange County's recovery was also twitter than might have been expected. It had to cut back on spending and social service pro vision, and in 1995 and 1996 it took on massive additional debt in the tom of specialiono-term recovery bonds" to cover its losses. But thanks to increased tax revenue from a buoyant local economy was able to exit from bankruptcy in only 18 months With new executives in charge Insted a series of gove once Structures and reforms. These included oversight committees on Internal auditor who reported directly to the supervisors, a com the rates by some 2.25 per cent francia frestorm was over-butils over the course of 1994. By Nor losses hod crystolised at around ember, the investment pool was in $1.69 billion. Some expert commen Crisis at the value of its interest rate lators have argued that it could sensitive medium-term investments have cut this bill only it hod hod sonk ond calls for more collateral the nerve to hang onto some of arrived from Wol Street Citron's investment portfolio tron's counterparties prepared But this makes it difference to to seize and ludote bilions of dol the fundamental lessons to be lors of the investment pool's collat leamed from the debacle. Citron orol while the government ontitis exposed a set of conservative that had invested in the fund, lock investors with specific funding ing credible rassurances, looked needs to a risky portiolo. Ho faled to withdraw their money. On to communicate the extent of the December 1. Chron admitted the market risk, or quity risk to either fund had lost round $1.5 bilion or the investors or to his supervisory Ground 20 per cent of its value. He boord-mough he did not try to resigned on December 3. os Hide the fundamentals of his strot- Orange County officia desper egy. Hoa he properly assessed otely led to work out an agree and communicated the level of ment with ther Wot Street creditors risk the pool would not have June 2001 OK ERisk.com of the ment that it had acted finally made good in February "Opony and professionally in our 2000. officers appointed by the relationship with ronge County courts paid out around $864 milion cited the contraction and to various government entities that uncertainty of the final hod sullered from the colapse. Five the reason had come to make years on from the bar voley. such an expensive settlement was a big day for the male credi we ough investors that for But on the come doy Orange had ready cerved against County supervisor im Silva wuch an outcome reminded local reporter that the Together with softlements from county it was still paying off more than 30 other securities some 51.2 bilion of the recovery houses, low firms and accountancy bands issued in 1995 and 1996- fers that the county held partly and would be for several decades responsible for the lose the unless was able to speed up money tom Menil Lynch meant repayments. that some 200 municipal and gov Rob Jameson is reference editor ernment agencies could be at ERR Resources and References Mark Boidossere. When Government Fake The Orange County Boty Public Policy Institute of California and the University of Cailloma Press, 1998 Overview coloble here mitment to long-range financial planning and a stricter written pol icy for investments in December 1997. Moody's Investor Service tewarded the county with on investment grode roting for key borrowing The new Orange County Invest ment policy statement established safety of principal and quidity, as the primary objectives of the fund with yield as a secondary objec live. More specifically prohibits bonowing for investment purposes le leverage). reverse repurchase ogreements, most kind of struc tured notes such Inverse floolers and derivatives such as options. The come document bons the treasury oversight committee and other designated employees from receiving gitts and obliges them to disclose economic interes and conficts of interest. The courly tremurer now has to submit monthly reports to the investors and other key county officers that con tain suficient information to permit on informed outside reader to eval uate the performance of the next ment programme On June 2. 1998. Orange County reached a massive $400 million sot tement with Marilynch, the finit held most responsible for steering Citron towards what the county doomed risky and unutable cu fot. Thomas Hayes, who led the county's Stigation sold he regarded the settlement as fair while onice Mittermeier, Orange County CEO in its recovery period. soid the resolution owes County taxpayers that those responsible for the losses that caused the county's bankruptcy are being held Decountable Merrill Lynch maintained as port Steven Cohen and William timicke Public Entrepreneurshe Ethical A Second Look at meary and Practice see section on the Francia Colople of Orange County, which discusses the high regard in which Robert Cihon was held before he fail from grace. Michel Crouby, Dan Gatal and Robert Mark Rak Management, McGwHIL 2001. Doge 34 ovaloble through www.omozon.com Bichard Irving County in Chit", Rick, March 1995. pp. 27-33 Philippe Jorion and Robert Roper Big Be Gone Boat Denvatives and Bonnicy in Gronge County, Academic Press 1995. available through woman.com Philippe Jodier's met come study. "Orange County Cote- Yetisk to Control Financial Orange County press release Bankuptcy Court wie Her County Come Against investment Broker Lynch. December 1, 1995 Boris Bonhom Tocal Hero" Treasury and Hisk Management Moga October 1998 une 2001