BACKGROUND OF THE CASE The bankruptcy of Orange County, California on December 6, 1994 was brought by Robert Citron who was the longtime Treasurer-Tax Collector and it was declared as the largest municipality of bankruptcy in U.S. history. He controlled several Orange County funds including the General Fund, the Investment Pool, and the treasury Commingled Pool.
By 1994, in charge of the Orange County Investment Pool, Citron had about $7.6 billion in deposits in the pool from the county government and almost 200 local public agencies. Some of these agencies were required to invest their funds in the County Investment Pool.
In a time of strong opposition to raising taxes, there were increased demands for county services. Thus, Citron had an investment strategy to earn high incomes for the county. As a controller, he had taken a highly leveraged position using repurchase agreement (repos) and floating rate notes (FRNs). It was being a highly leveraged for rising federal interest rate as the usage of these financial instruments reached the amount of $2 billion, thus the loss had incurred.
His strategy was to use the funds on deposit to borrow money to invest in derivatives, inverse floaters, and long term bonds that paid high yields. To obtain the degree of leverage which the amounts were ranging from 158% to over 292%, Citron used treasury bonds as collateral. The size of the pool increased to $20.6 billion as he borrowed $2 for every $1 on deposit. According to The Wall Street Journal, he was "borrowing short to go long", and investing the dollars in securities whose yields were inversely related to interest rate.
Profits from the fund were excessive for a period of time. However, Citron had turned to hide the excess earnings. He pleaded guilty to improperly transferring securities from the Orange County General Fund to the Orange County Treasury Commingled Pool. However, the fact of the county's finances was not in doubt until February 1994. The Federal Reserve Bank began to raise the US interest rate which caused many securities in Orange County's investment pools to depreciate in value.
In December 1994, Credit Suisse First Boston (CSFB) realizes what had happened and blocked the extension of issuing another repo at the new prevailing interest rate. In November, auditors told county officials that Citron had lost $1.64 billion. In early December, the supervisors realized that the county did not have the cash to withstand a run on the money by Wall Street lenders and the local-government pool depositors. With that, the financial house came down.
Thus, the supervisors asked for and got Citron's resignation. As the country unsuccessfully tried to sell off the risky securities, the lenders threatened to take the position; legally, the county pool securities they held as collateral. After the first bank took this action, the county government declared bankruptcy on December 1994.
THE AFTERMATH : RESTITUTION AND RECOVERY
Robert Citron admitted guilty for six felony counts. Citron does not seem to have been motivated by personal gains since the charges were large if he wants to do with a misallocation of returns between the county and other municipal entities. He paid a $100, 000 fines and spent less than a year under house arrest. Orange County had shortened on spending and social service provision. Orange County took on massive additional debt in the form of special long-term recovery bonds to cover it losses. Orange County was being able to exit from bankruptcy in only 18 months because of the increasing tax revenues from a local economy.
Orange County instituted a series of governance structures and reforms under the control of new executives. These included oversight committees, an internal auditor who reported directly to the supervisors, a commitment to long-range financial planning and a stricter written policy for investments. In December 1997, Moodys Investors Service rewarded the county with an investment grade rating for key borrowings.
The new Orange County investment policy statement establishes safety of principal and liquidity as the primary objectives of the fund with yield as a secondary objective. It prohibits borrowing for investments purposes such as leverage, reverse repurchase agreements, some kinds of structured notes such as inverse floaters and derivatives such as options. The same document prohibits the treasury oversight committee and other selected employees from receiving gifts and requires them to disclose economic interests and conflicts of interest. Every month, the county treasurer needs to submit reports to the investors and other key county officers that contain enough information to permit and informed outside reader to evaluate the performance of the investment program.
Orange County reached a massive $400 million settlement with Merrill Lynch on June 2, 1998, the firm it held most responsible for guiding Citron towards what the county considered risky and inappropriate securities. The County's litigation leader Thomas Hayes said he regarded the settlement as fair while Janice Mittermeier, Orange County CEO in its recovery period, said the resolution convinced county taxpayers that those responsible for the losses that caused the county's bankruptcy are being held accountable.
Merrill Lynch maintained as part of the settlement that it had acted properly and professionally in our relationship with Orange County. It mention in an official method that the costs, distraction and uncertainty of further litigation as the reason it had come to make such an expensive settlement, while convinced its investor that it had already fully reserved against such consequence.
Together with settlements from more than 30 other securities houses, law firms and accountancy firms that the county held partly responsible for the losses, the money from Merrill Lynch meant that some 200 municipal and governmental agencies could be finally made good. In February 2000, officers selected by the courts paid out around $864 million to various government entities that had suffered from the collapse. Five years on from the bankruptcy, it was a big day for the smaller creditors. But on the same day, Orange County supervisor Jim Silva reminded local reporters that the county itself was still paying off some $1.2 billion of the recovery bonds issued in 1995 and 1996 and would be for several decades, unless it was able to speed up repayments.
LESSONS LEARNT
If the organizational structure, planning and risk oversight mechanisms of an institution are fractured, it is easy for powerful individuals to hide risk in the gaps.
Borrowing short and investing long means liquidity risk, as every bank knows.
Risk-averse investors must tie investment objectives to investment actions by means of a strict framework of investment policies, guidelines, risk reporting and independent and expert oversight.
Risk reporting should be complete, and easily comprehensible to independent professionals. Strategies that are not possible to explain to third parties should not be employed by the risk averse.
Local governments need to maintain high standards for fiscal oversight and accountability.
The State of California should revise the law governing the structure of its counties.
State government should closely monitor the fiscal conditions of its local governments, rather than wait for serious problem to surface.
Local officials should be wary about citizens' pressures to implement fiscal policies that are popular in the short run but financially disastrous over time.
