Orange County Case

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.

That run became a walk and very soon a descent into investment hell, when the Federal Reserve started raising interest rates. This meant the calls for more collateral increased from his counterparties. The notional losses increased and members of the pool started requesting their shares back. This resulted in the form of a liquidity trap.

The counterparties started liquidating billions of dollars of the pool collateral. Government agencies invested in the pool were looking at ways to exit. The Orange County board of supervisors then declared bankruptcy to prevent investors from further removing their funds. A public auction of the investments in the pool was conducted and the proceeds parked in safer, liquid short-term government stocks. Post this restructuring, losses still stood at $1.69 billion.

Orange County took recovery bonds as debt. The county had to cut severely on its spending and social services provisions. The local economy was doing very well and in a matter of 18 months was able to haul itself out of bankruptcy.

Orange County was able to turn itself around from a position of temporary weakness by instituting stronger governance reforms.

An oversight committee, an internal auditor who reported to the Board of supervisors, written policies on investment and a definite plan and orientation for long term financial planning were some of the changes Orange County made. The policy gave top priority to liquidity and safety of principal, with yield having secondary priority. The needs of the county by ploughing their funds for investment were certainly not for higher yields at the cost of incurring losses, due to market risk in the case of Orange County. To this end the County’s investment policy disallows investment in reverse repos, structured notes and options. It requires that timely reports be presented to the board. It clearly says that any decision making member cannot accept gifts in kind or cash.

The Orange County also reached a settlement with Merrill Lynch through litigation. As part of the settlement Merrill Lynch had to pay the county $400 million for improper advice towards risky instruments that were clearly at odds with the funding needs of the pool. Thirty other firms that included accountancy firms, law firms also reached settlements with the County. This money was then used by about 200 municipal agencies. These settlements made by officers of the court reached $864 million.

What then are the lessons that we need to take away from the Orange County Crisis?

1. A good track record and a star performer are great during a good run. It is important to be aware that where there are higher returns there is higher risk as well, which will up its ante sooner or later.
2. It is important, and critical for a good framework in place that understands the organisations investment objectives. Planning for these investment objectives needs to be a decision members of the pool make. The investment decisions should not be centered on one or two individuals. If not this can lead to poor oversight and eventually very costly mistakes.
3. Organisations that invest long by borrowing short will definitely have to face liquidity risk.
4. A framework of investment policies, guidelines, and risk reporting and independent and expert oversight can help make a happy marriage of risk-averse investors with investment objectives to investment actions.
5. Clear and easy risk reports that are comprehensible by all parties is fundamental to good investment. This way all parties concerned will be on the same page with regards to what is happening to the investments. Complicated instruments or strategies that cannot be explained to third parties must be eschewed, particularly by the risk averse.