O R A N G E C O U N T Y B A N K R U P T C Y

HISTORY OF MUNICIPAL BOND DEFAULTS

PRESENTED BY:WENQIAN CHEN (FRANCES)

APRIL 30TH, 2013

AGENDA

What is Municipal bond?

What is default? Default risks?

What happened to Orange county in 1994? Why?? How???

Summary

MUNICIPAL BONDBrief Introduction

A Municipal bond is issued by a local government or agencies.

Municipal bonds may be general obligations of the issuer or secured by specified revenues.

interest income received by holders of municipal bonds is often exempt from federal and state income tax.

municipal bonds are free to trade at any time once they are purchased by the investor.

Rm=Rc (1-t)

TYPES AND RISKS

General Obligation Bond

Taxing authority unable to raise sufficient revenue to meet debt

obligations

issued with the belief that a municipality will be able to repay its debt obligation through taxation or

revenue from projects. No assets are used as collateral.

Revenue Bond

finance income-producing projects and are secured by a specified

revenue source. can be repaid through a variety of tax

sources

Revenue stream is inadequate to meet debt obligation

Written Financial Plan

DEFAULTS

A default is a situation when a debt obligation is not met, that is, the principal or interest payments are not paid when they are due.

In the event of a default, bondholders seldom lose all of their principal value of the bond. Often, a default could result in the suspension of the coupon payment.

DEFAULT RISK (CREDIT RISK)

Municipal defaults usually follow downswings in business cycles and more likely to occur in high growth areas that borrow heavily.

Credit Risk Ratings: scale is AAA, AA, A, BBB, BB, B, CCC, CC, C, and rating D for bonds in arrears

Five major bond rating agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and A.M. Best.

ORANGE COUNTY BANKRUPTCY

Robert Lafee Citron: Democratic politician party who was the longtime Treasurer-Tax Collector of Orange County, California, when it declared bankruptcy on December 6, 1994.

1985: Earned $172 million for the county

1992: European currency market crisis forced him to sell $400 million in complicated securities.

1994: Lost $1.6 M, defaulted $1 M in 1995

Rising interest rates: wrong answer from Robert.

ORANGE COUNTY BANKRUPTCY

Local agencies required to invest in county investment pool, attracted by high interest rate Citron advertised.

Strategy: “Borrowing short to go long”• use funds in deposit to borrow money to invest in derivatives and long-

term bonds (high yield)• Borrow more money as collateral• Rely heavily on interest income (12% of revenue for OC, 3% for other

California Counties)• Took more risks.• Size of the pool increased to $20.6 M, as he borrowed $2 on $1 on

deposit

INVEST IN SECURITIES YIELDS INVERSELY RELATED TO INTEREST RATES

HOW THE INVESTMENT POOL WORKED

Taxes, Bond sales, Other

sources

CITIESInvestment

Pool

CITIESPayroll, Road

Repairs

Investment Pool

Arbitrage strategy

Take money from county investment

pool

Buy bonds

Put bonds up for collateral

to WS lenders in exchange of

cash

Purchase more bonds

HOW DID IT HAPPEN

Fiscal Austerity

Pressure to raise funds for services

Political Fragmentatio

nSeparate policies without regional

coordination

Voter DistrustPolitics and

elections domination

Bankruptcy

SUMMARY

• Introduction of municipal bonds• Types of municipal bonds• Default risks• Orange county bankruptcy

REFERENCE

http://en.wikipedia.org/wiki/Robert_Citron

http://www.investopedia.com/terms/d/default2.asp

http://www.municipalbonds.com/education/read/77/default-rates-of-municipal-bonds

http://www.investopedia.com/ask/answers/08/orange-county-bankruptcy.asp

http://merage.uci.edu/~jorion/oc/track.gif