Defaults on Municipal Bonds Mandy Swanson

Overview  Historic Default Rate  Orange County  Washington Public Power Supply System  Conclusion

History of Defaults  From default rate only 1.1%  1920’s, 1930’s (depression), 1980’s, and 1990’s  Orange County – 1994  WPPSS

Orange County, California  Not only the place for a hit TV shows and Movies….  Home of the Largest Municipal Bond Default in History

Background:  Wealthy and politically conservative county.  The pool handled funds on behalf of 194 public bodies  Traditional Bond Pools invest in low risk securities.

Robert L. Citron, Treasurer  Risky Investments  Big Bets, Gone Bad Interest Rates Decrease: GOOD! Interest Rates Increase: BAD!!

Players in Downfall:  Repos (Repurchase Agreement)  Contract between seller and buyer that stipulates the sale, and later repurchase, of securities at a specific date and price.  Example: take a loan out on the house, put the house up, and repurchase house later for a price that includes loan amount, plus interest.

Reverse Repos:  Reverse Repos  The dealer (buyer) trades money for securities, agreeing to resell them later.  It’s a way for seller to get additional funds  OC repos spanned 3-6 months.  The newly invested bonds pays a coupon that is higher than the repo interest rate.  Earn money on margins, IF interest rates go down or stay constant.

Reverse Repo Example:  OCIP sells bond to dealer (CSFB), repurchase 30 days at fixed price. Coupon rate of bond is 5.38%  CSFB would then sell the bond to another client.  OC received $100 million for bond. Repo rate= 3% APR for 30 days.  Interest:  100 Million X 3% * (30/360) = $250,000  End payment would be $100,250,000.  In meantime, OCIP invest back in another bond with coupon payment of 5.38% (that’s an earnings margin of 5.38% - 3.0% = 2.38%!)  100 million X ( )* (30/360) = 198,333

Reverse Repo:  Profitable if interest rates go down or stay the same, lose money on the margin if interest rates go up.  Rates low Citron, in 1991, he had a leverage of 3 to 1 on reverse repos:  Total Exposure: 300M = Initial Note (100M) + First Reverse RP (100M) + Second Reverse RP (100M)

What if interest rates go up?  Interest rate risk: interest Increase then securities price decreases.  If rates go up to 7.88% (from 5.34%) the prices of securities drop well below $100 dollar par value  OCIP Exposure: 3X the original amount with interest increase  One Repo drops price from $ to $95.80  Second Repo drops price further to $87.40  Citron promised to buy back at $100.00, can only sell his bonds for $87.40.

Repos can be rolled over:  If rates go up, the dealer will request additional funds as collateral.  To roll over, if borrowed $100 Million in bonds, and value of the bonds fell $8 Million, then the dealer would ask for additional $8 Million as collateral.  With OCIP  Dealer 1 requests $8 Million  Dealer 2 requests $8 Million.  Total = $16 Million to rollover Repos.  OCIP had to come up with over $515 million to roll over Repos.  OCIP failed to meet the rollover call prices.

Players in Downfall:  Derivatives: assets that derive from that of some underlying assets.  The return on a derivative is linked to the performance of the underlying asset (bond, currency, commodity).  Derivative examples: Options, Swaps, Futures contracts, and Forward Contracts.  Derivatives: highly exotic, unregulated, misunderstood.

Players in Downfall:  Structures Notes:  Inverse floaters: where if interest rates go down, coupon payment goes up  Very sensitive to movements in interest rates  OC took tons of Inverse Floaters from agencies such has Fannie Mae.  Basically took these notes betting on stable or falling interest rates.

Pool Performance: Before 1994 OC pool was performing better than state pool. ($755 million better)  Everyone wanted “in” Few were skeptical  Citron was even re-elected

Interest Rates: Federal Reserve Bank Raised Interest to combat inflation in 1994.

What did Citron Do Early 1994??  Even after rates started to rise.  First: Citron leveraged portfolio more with another $12.6 billion worth of repos, then invested that money in other notes and bonds.  Second: increased leverage further by buying about $8 billion in structured notes.  “Double Up” Strategy

Investor Scare:  Investors pulled money out  Cash flow decreased

Results:  1.7 BILLION! LOSS and County Bankruptcy  That is more money than the GDP of many small nations!

Results?  1996 Recovery Certificates  Lowered Credit Rating  Cut Expenses (layoffs, public service cuts)  So Far the county has recovered about $680 Million  Government has passed legislation to prohibit bond issuers from dealing in options when making investment.

John M. W. Moorlach, CPA  Citron Resigned  New Treasurer, has instituted new policies for investment pools

Washington Public Power Supply System (Whoops)

WPPSS Background:  Established in 1954 to Build Power Generation Facilities  Predicted that demand for electricity would double every 10 years.  Plan for 5 Plants

Problems:  Inflation  Design changes  Safety changes  Mismanagement  Investor Skepticism

Management:  Responsible for cost increases and schedule delays.  Growth threshold challenges  Organizational size and structure was not changed to accommodate the growth of the plants  Slow delegation to lower levels (lower management were underdeveloped and underutilized.  Tradition to promote from within and familiar people, rather than recruit top executives with experience.

Board of Directors:  Small time directors, who were successful only in smaller businesses.  Types of Members:  Wheat ranchers, apple orchard owners, veterinarians, muffler shop owners, and refrigerator salesmen.  One a few were professional, and of those virtually none had any high level managerial experience with nuclear power.  At meetings, in a 2 hour meeting only about 3 minutes was devoted to policy considerations.

Planning and Budgeting:  Budget emphasized financial control and accountability rather than planning and performance.  Decisions made without serious consideration of goals.  Budget reductions made with no regard for in- put from department managers or department goals.  Typical budget policy of a much smaller organization.  Lack of central coordination of the budget process lead to poor construction cost data.

Cost Increases:  Labor Costs: higher costs with lower productivity.  Regulatory Changes: 1,000 new regulations in the 1970’s (although not all caused increases in costs)  Contract Increases: if costs of project overrun beyond contactor’s control. (project design changes, schedule revisions, etc)

Plant Production Haulted:  1982: Plants 4 and 5 halted  Budgets exceeding $24 Billion, and neither made money, or power.  Plants 1 and 3 were never completed either  Losses covered by the Bonneville Power Administration

Results:  Losses of 2.25 Billion, and resulted in system default.  Member utilities, specifically rate payers, were held responsible to pay back money.

Lawsuit:  Bondholders Sued….  30,000 bondholders got $0.40 on the dollar, and the rest received as low as $0.10 on the dollar.

Conclusion  Even though defaults are rare, when they do occur they have significant impacts.  Promotes Diversification!!!  Can get insurance to help cover the chance of defaults, this insurance basically lowers coupon payments slightly.

Questions??