Two essays on the contagion vs. competitive effects of bankruptcy announcements: Case studies of Orange County, California, and long-term capital management

Date of Completion

January 2001


Business Administration, Management|Economics, Finance




We examine the contagion, competitive, and direct effects of two significant events: (1) the December 1994 bankruptcy announcement of Orange County, California, the largest municipal bankruptcy in U.S. history, and (2) the September 1998 negative earnings and near bankruptcy/rescue announcements of Long-Term Capital Management (LTCM), a highly-leveraged hedge fund. In addition to finding support for direct effects, we find that the Orange County bankruptcy led to contagion effects for non-Orange County municipal bonds and municipal bond funds that did not own Orange County municipal bonds. Also, the Orange County bankruptcy negatively impacted derivative dealer banks and user banks; however, since they have no exposure to derivatives, non-derivatives banks were not impacted by the bankruptcy. We find that in addition to negatively affecting financial firms directly exposed to LTCM, the negative earnings and near bankruptcy/rescue announcements led to contagion effects for financial firms that were not directly exposed to LTCM and those with no hedge fund exposure. These results confirm that hedge funds are riskier than other types of financial firms. Since our results for both studies are more negative than the results obtained by many previous contagion studies, there is justification, in the case of the Orange County bankruptcy, to regulate municipalities' investments and to further regulate the derivatives market to reduce the likelihood of any future occurrences, and, in the case of the LTCM episode, to regulate hedge funds and the financial firms that have exposure to them to reduce the potential negative externalities that could result from a hedge fund failure. ^