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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

Orange County's investment pool, managed by Robert Citron, was heavily leveraged through reverse repos and held structured notes. Approximately what happened to the pool's value when rates rose sharply in 1994?

The pool lost roughly $1.6 billion and Orange County filed for bankruptcy in December 1994. Leveraged positions in long-duration structured notes, financed by reverse repos, were hit hard when the Fed raised rates in 1994. The losses stemmed from interest rate risk, not issuer credit defaults.

  1. AThe pool gained because floating-rate notes reset higher
  2. BThe pool lost about $1.6 billion, and the county filed for bankruptcy in December 1994Correct
  3. CThe pool was unaffected because it was hedged with swaps
  4. DThe pool lost its principal only on credit defaults of note issuers

Explanation

The pool bet that rates would stay low or fall. Leverage via reverse repos magnified the losses on long-duration, inverse-floater-type securities when the Fed raised rates in 1994. Realized losses were about $1.6 billion, leading to the county's Chapter 9 filing in December 1994. Losses were from interest rate risk, not credit defaults.

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