Orange County Case

The importance of a good risk management team that oversees investments is critical in an institution. This is especially more so for a County. The Orange County ran into very troubled investment waters in 1994. Litigation and a buoyant economy helped right many of the wrongs. It was a very expensive way, of about $1.6 billion from a wrong way bet on interest rates in an investment pool that caused Orange County to take a hard look at its system of checks and balances as far as their investments were concerned.

Robert Citron the principal player in the Orange County debacle took money raised by public departments for public works, placing yields over safety of the resources. He invested this money in leveraged portfolios.  These portfolios were linked to interest rate securities. The pool he used for these leveraged investments had the county and 241 associated entities.

Robert Citron had an enviable track record of managing the investment pool that had become about $7.5 billion by the 90’s. The various participants in the pool hoped to get better returns for their currently idle cash which they could deploy later for public works. Citron who had been managing the funds since the 70’s had created reserves worth several millions of dollars leading up to the debacle in 1994. Citron had a fairly free hand in investment decisions with low priority on reporting. The public agencies too had pressure on them not to raise taxes, but to deliver on development. This meant most of these agencies were looking for higher returns on their funds.

Citron’s strategy was dependent on the presumption that the interest rates for the short term would be fairly low compared to medium term investments. Citron managed to get the best returns by taking on more risk. He used highly leveraged portfolios to invest his money to raise the value of his $7.5 billion pool to $20 billion. He achieved this by investing in reverse repurchase agreements, which permitted him to use securities bought by the pool as collateral for further investments. Naturally this left the door open on the possibility that the value of his original collateral fell, and he would be required to provide more collateral in the event of a loss.

There was an oversight committee comprised of the board of supervisors, who unfortunately despite having to supervise Citron, lacked the financial sophistication to do so. So Citron continued, undisturbed. His principal advisors for the kind of instruments he could invest in were Merrill Lynch. Citron invested in a variety of Government paper. He also invested in derivatives, $2.8 billion of it, in order to increase his bet on the yield curve structure. Inverse floaters, index amortizing notes and collateralized mortgage obligations-Citron’s pool had a finger in every pie.

These instruments’ complexity and Citron’s lack of reporting made the returns that were better than most other counties all a bit of magic that could not be understood and most certainly not predicted. The portfolio under Citron’s guidance was having a golden run, and nobody was complaining.