Defaults on Defaults on Municipal BondsMunicipal BondsMandy SwansonMandy Swanson

OverviewOverview

Historic Default RateHistoric Default Rate Orange CountyOrange County Washington Public Power Supply SystemWashington Public Power Supply System Conclusion Conclusion

History of DefaultsHistory of Defaults

From 1940-1999 default rate only 1.1%From 1940-1999 default rate only 1.1% 1920’s, 1930’s (depression), 1980’s, and 1920’s, 1930’s (depression), 1980’s, and

1990’s1990’s Orange County – 1994Orange County – 1994 WPPSS - 1982WPPSS - 1982

Orange County, CaliforniaOrange County, California

Not only the place for a hit TV shows and Not only the place for a hit TV shows and Movies….Movies….

Home of the Largest Municipal Bond Home of the Largest Municipal Bond Default in HistoryDefault in History

Background:Background:

Wealthy and politically Wealthy and politically conservative county.conservative county.

The pool handled funds The pool handled funds on behalf of 194 public on behalf of 194 public bodiesbodies

Traditional Bond Pools Traditional Bond Pools invest in low risk invest in low risk securities.securities.

Robert L. Citron, Robert L. Citron, TreasurerTreasurer

Risky InvestmentsRisky Investments Big Bets, Gone BadBig Bets, Gone Bad

Interest Rates Decrease: GOOD!Interest Rates Decrease: GOOD! Interest Rates Increase: BAD!!Interest Rates Increase: BAD!!

Players in Downfall:Players in Downfall:

Repos (Repurchase Repos (Repurchase Agreement)Agreement) Contract between seller and Contract between seller and

buyer that stipulates the sale, buyer that stipulates the sale, and later repurchase, of and later repurchase, of securities at a specific date securities at a specific date and price.and price. Example: take a loan out on the Example: take a loan out on the

house, put the house up, and house, put the house up, and repurchase house later for a repurchase house later for a price that includes loan amount, price that includes loan amount, plus interest.plus interest.

Reverse Repos:Reverse Repos:

Reverse Repos Reverse Repos The dealer (buyer) trades money for The dealer (buyer) trades money for

securities, agreeing to resell them later.securities, agreeing to resell them later. It’s a way for seller to get additional funds It’s a way for seller to get additional funds OC repos spanned 3-6 months.OC repos spanned 3-6 months. The newly invested bonds pays a coupon The newly invested bonds pays a coupon

that is higher than the repo interest rate.that is higher than the repo interest rate. Earn money on margins, IF interest rates go Earn money on margins, IF interest rates go

down or stay constant. down or stay constant.

Reverse Repo Example:Reverse Repo Example: OCIP sells bond to dealer (CSFB), repurchase 30 OCIP sells bond to dealer (CSFB), repurchase 30

days at fixed price. Coupon rate of bond is 5.38%days at fixed price. Coupon rate of bond is 5.38%

CSFB would then sell the bond to another CSFB would then sell the bond to another client.client.

OC received $100 million for bond. OC received $100 million for bond. Repo rate= 3% APR for 30 days.Repo rate= 3% APR for 30 days.

Interest: Interest: 100 Million X 3% * (30/360) = $250,000100 Million X 3% * (30/360) = $250,000

End payment would be $100,250,000.End payment would be $100,250,000.

In meantime, OCIP invest back in another bond In meantime, OCIP invest back in another bond with coupon payment of 5.38% (that’s an with coupon payment of 5.38% (that’s an earnings margin of 5.38% - 3.0% = 2.38%!)earnings margin of 5.38% - 3.0% = 2.38%!)

100 million X (5.38-3.00)* (30/360) = 198,333100 million X (5.38-3.00)* (30/360) = 198,333

Reverse Repo:Reverse Repo: Profitable if interest rates go down or stay Profitable if interest rates go down or stay

the same, lose money on the margin if the same, lose money on the margin if interest rates go up.interest rates go up.

Rates low Citron, in 1991, he had a Rates low Citron, in 1991, he had a leverage of 3 to 1 on reverse repos:leverage of 3 to 1 on reverse repos: Total Exposure: 300M = Initial Note (100M) Total Exposure: 300M = Initial Note (100M)

+ First Reverse RP (100M) + + First Reverse RP (100M) + Second Reverse RP (100M)Second Reverse RP (100M)

What if interest rates go What if interest rates go up?up? Interest rate risk: interest Increase then Interest rate risk: interest Increase then

securities price decreases.securities price decreases. If rates go up to 7.88% (from 5.34%) the prices If rates go up to 7.88% (from 5.34%) the prices

of securities drop well below $100 dollar par of securities drop well below $100 dollar par value value

OCIP Exposure: 3X the original amount with OCIP Exposure: 3X the original amount with interest increase interest increase One Repo drops price from $100.00 to $95.80One Repo drops price from $100.00 to $95.80 Second Repo drops price further to $87.40Second Repo drops price further to $87.40

Citron promised to buy back at $100.00, can Citron promised to buy back at $100.00, can only sell his bonds for $87.40.only sell his bonds for $87.40.

Repos can be rolled over:Repos can be rolled over: If rates go up, the dealer will request additional funds as If rates go up, the dealer will request additional funds as

collateral.collateral. To roll over, if borrowed $100 Million in bonds, and value To roll over, if borrowed $100 Million in bonds, and value

of the bonds fell $8 Million, then the dealer of the bonds fell $8 Million, then the dealer would ask for additional $8 Million would ask for additional $8 Million as collateral. as collateral.

With OCIPWith OCIP Dealer 1 requests $8 MillionDealer 1 requests $8 Million Dealer 2 requests $8 Million.Dealer 2 requests $8 Million. Total = $16 Million to rollover Repos.Total = $16 Million to rollover Repos.

OCIP had to come up with over $515 million to roll over OCIP had to come up with over $515 million to roll over Repos.Repos.

OCIP failed to meet the rollover call prices.OCIP failed to meet the rollover call prices.

Players in Downfall:Players in Downfall: Derivatives: assets that derive from that of Derivatives: assets that derive from that of

some underlying assets.some underlying assets. The return on a derivative is linked to the The return on a derivative is linked to the

performance of the underlying asset (bond, performance of the underlying asset (bond, currency, commodity).currency, commodity). Derivative examples: Options, Swaps, Futures contracts, Derivative examples: Options, Swaps, Futures contracts,

and Forward Contracts.and Forward Contracts.

Derivatives: highly exotic, unregulated, Derivatives: highly exotic, unregulated, misunderstood.misunderstood.

Players in Downfall:Players in Downfall:

Structures Notes:Structures Notes: Inverse floaters: where if interest rates go Inverse floaters: where if interest rates go

down, coupon payment goes updown, coupon payment goes up Very sensitive to movements in interest Very sensitive to movements in interest

ratesrates OC took tons of Inverse Floaters from OC took tons of Inverse Floaters from

agencies such has Fannie Mae.agencies such has Fannie Mae. Basically took these notes betting on stable Basically took these notes betting on stable

or falling interest rates.or falling interest rates.

Pool Performance:Pool Performance:Before 1994Before 1994

OC pool was performing better than state OC pool was performing better than state pool. ($755 million better)pool. ($755 million better) Everyone wanted “in” Few were skepticalEveryone wanted “in” Few were skeptical

Citron was even re-elected Citron was even re-elected

Interest Rates:Interest Rates:

Federal Reserve Bank Raised Interest to combat inflation in 1994.

What did Citron Do Early What did Citron Do Early 1994??1994?? Even after rates started to rise. Even after rates started to rise.

First: Citron leveraged portfolio more with First: Citron leveraged portfolio more with another $12.6 billion worth of repos, then another $12.6 billion worth of repos, then invested that money in other notes and invested that money in other notes and bonds. bonds.

Second: increased leverage further by Second: increased leverage further by buying about $8 billion in structured notes.buying about $8 billion in structured notes.

““Double Up” StrategyDouble Up” Strategy

Investor Scare:Investor Scare:

Investors pulled money outInvestors pulled money out Cash flow decreasedCash flow decreased

Results:Results:

1.7 BILLION! LOSS and 1.7 BILLION! LOSS and County BankruptcyCounty Bankruptcy That is more money than That is more money than

the GDP of many small the GDP of many small nations!nations!

Results?Results? 1996 Recovery Certificates1996 Recovery Certificates Lowered Credit RatingLowered Credit Rating Cut Expenses (layoffs, public service cuts)Cut Expenses (layoffs, public service cuts) So Far the county has recovered about $680 So Far the county has recovered about $680

MillionMillion

Government has passed legislation to prohibit Government has passed legislation to prohibit bond issuers from dealing in options when bond issuers from dealing in options when making investment.making investment.

John M. W. Moorlach, CPAJohn M. W. Moorlach, CPA

Citron ResignedCitron Resigned New Treasurer, has instituted new New Treasurer, has instituted new

policies for investment poolspolicies for investment pools

Washington Public Power Washington Public Power Supply System (Whoops)Supply System (Whoops)

WPPSS Background:WPPSS Background:

Established in 1954 to Build Power Established in 1954 to Build Power Generation FacilitiesGeneration Facilities

Predicted that demand for electricity Predicted that demand for electricity would double every 10 years.would double every 10 years.

Plan for 5 PlantsPlan for 5 Plants

Problems:Problems:

InflationInflation Design changesDesign changes Safety changesSafety changes Mismanagement Mismanagement Investor SkepticismInvestor Skepticism

Management:Management:

Responsible for cost increases and schedule Responsible for cost increases and schedule delays.delays. Growth threshold challengesGrowth threshold challenges

Organizational size and structure was not changed to Organizational size and structure was not changed to accommodate the growth of the plantsaccommodate the growth of the plants

Slow delegation to lower levels (lower management were Slow delegation to lower levels (lower management were underdeveloped and underutilized.underdeveloped and underutilized.

Tradition to promote from within and familiar people, rather Tradition to promote from within and familiar people, rather than recruit top executives with experience.than recruit top executives with experience.

Board of Directors:Board of Directors:

Small time directors, who were successful only Small time directors, who were successful only in smaller businesses.in smaller businesses.

Types of Members:Types of Members: Wheat ranchers, apple orchard owners, Wheat ranchers, apple orchard owners,

veterinarians, muffler shop owners, and refrigerator veterinarians, muffler shop owners, and refrigerator salesmen.salesmen.

One a few were professional, and of those virtually One a few were professional, and of those virtually none had any high level managerial experience with none had any high level managerial experience with nuclear power.nuclear power.

At meetings, in a 2 hour meeting only about 3 At meetings, in a 2 hour meeting only about 3 minutes was devoted to policy considerations.minutes was devoted to policy considerations.

Planning and Budgeting:Planning and Budgeting:

Budget emphasized financial control and Budget emphasized financial control and accountability rather than planning and accountability rather than planning and performance.performance.

Decisions made without serious consideration Decisions made without serious consideration of goals.of goals.

Budget reductions made with no regard for in- Budget reductions made with no regard for in- put from department managers or department put from department managers or department goals.goals.

Typical budget policy of a much smaller Typical budget policy of a much smaller organization.organization.

Lack of central coordination of the budget Lack of central coordination of the budget process lead to poor construction cost data.process lead to poor construction cost data.

Cost Increases:Cost Increases:

Labor Costs: higher costs with lower Labor Costs: higher costs with lower productivity.productivity.

Regulatory Changes: 1,000 new regulations in Regulatory Changes: 1,000 new regulations in the 1970’s (although not all caused increases the 1970’s (although not all caused increases in costs)in costs)

Contract Increases: if costs of project overrun Contract Increases: if costs of project overrun beyond contactor’s control. (project design beyond contactor’s control. (project design changes, schedule revisions, etc)changes, schedule revisions, etc)

Plant Production Haulted:Plant Production Haulted:

1982: Plants 4 and 5 halted1982: Plants 4 and 5 halted Budgets exceeding $24 Billion, and neither Budgets exceeding $24 Billion, and neither

made money, or power.made money, or power.

Plants 1 and 3 were never completed Plants 1 and 3 were never completed eithereither Losses covered by the Bonneville Power Losses covered by the Bonneville Power

AdministrationAdministration

Results:Results:

Losses of 2.25 Billion, and resulted in Losses of 2.25 Billion, and resulted in system default.system default.

Member utilities, specifically rate payers, Member utilities, specifically rate payers, were held responsible to pay back were held responsible to pay back money.money.

Lawsuit:Lawsuit:

Bondholders Sued….Bondholders Sued…. 30,000 bondholders got $0.40 on the dollar, 30,000 bondholders got $0.40 on the dollar,

and the rest received as low as $0.10 on the and the rest received as low as $0.10 on the dollar.dollar.

ConclusionConclusion Even though defaults are rare, when they Even though defaults are rare, when they

do occur they have significant impacts.do occur they have significant impacts. Promotes Diversification!!!Promotes Diversification!!! Can get insurance to help cover the Can get insurance to help cover the

chance of defaults, this insurance chance of defaults, this insurance basically lowers coupon basically lowers coupon

payments slightly.payments slightly.

Questions??Questions??