Question

This question discusses Orange County Bankruptcy

1. Who is Robert Citron?
2. What was the Orange County Investment Pool and balance sheet (1994)?
3. What was Citrons Strategy?
4. Finally, what are the lessons to learn?

Answer 1

1) Who was Rober Citron?

Robert L. Citron was a former Orange County tax collector who presided over the county’s investments when it went into bankruptcy in 1994. He made millions of extra dollars for local governments with exotic investment schemes that soared over most everyone’s head. His bad bets on exotic Wall Street investments resulted in what at the time was the largest municipal bankruptcy in U.S. history. He died on Jan. 16 2013 at the age of 87.

At one point, Citron’s investments were earning 17.7 percent, and the county alone was raking in $344 million a year. Citron was furnishing 35 percent of the county budget, although government accounting standards say interest shouldn’t comprise more than 5 percent. He was lauded for his acumen. A new boldness possessed Citron in 1991. As recession drove interest rates down, he borrowed $2 for every $1 in the pool, plowed the money into even more complex securities and raked in even more cash.

Citron borrowed heavily to purchase volatile securities whose earnings were heavily tied to interest rates. When rates rose, the Orange County investment pool, which included funds from cities and school districts, lost $1.6 billion and plunged the county into bankruptcy. In 1994, his investments went awry and Orange County lost $1.64 billion, ushering county government into what was then the largest municipal bankruptcy in American history. Citron was forced to resign from the job.  A grand jury investigation found that the treasurer who over the years won so much praise for his investment skills relied upon a mail-order astrologer and a psychic for interest rate predictions as the county’s treasury began to decline.

2) What was the Orange County Investment Pool and balance sheet (1994)?

In 1994, Robert Citron was Treasurer-Tax Collector and the only Democrat to hold office in Orange County, California. Through a series of highly-levered deals that included repo agreements and floating rate notes, Citron was able to at one point achieve leverage of 292%. The funds he managed were worth around $8 billion and if interest rates went up, he stood to lose big time due to his collateral which consisted almost primarily of US Treasury bonds. However, the Interest rates rose and as a result, Orange County lost a huge amount of money.

The county's finances were not suspect until February 1994. The Federal Reserve Bank began to raise US interest rates, causing many securities in Orange County's investment pools to fall in value. As a result, dealers were requesting extra margin payments from Orange County. These extra margin payments were funded in part by another bond issue made by Orange County; the size of that bond issue was $600 million. However, this fix proved to be only temporary. In December 1994, Credit Suisse First Boston (CSFB) realized what was going on and blocked the "rolling over" of $1.25 billion in repos ("rollover" essentially means issuing of another repo when the previous one ends, but, at the new prevailing interest rate). At that point Orange County was left with no recourse other than to file for bankruptcy."

3) What was Citrons Strategy?

Citron borrowed heavily to purchase volatile securities whose earnings were heavily tied to interest rates. In 1991. as recession drove interest rates down, he borrowed $2 for every $1 in the pool, plowed the money into even more complex securities and raked in even more cash. When rates rose, the Orange County investment pool, which included funds from cities and school districts, lost $1.6 billion and plunged the county into bankruptcy. In 1994, his investments went awry and Orange County lost $1.64 billion, ushering county government into what was then the largest municipal bankruptcy in American history.

In 1993-1994, interest rates did exactly reverse. They rose. His ultra-risky, highly leveraged investments plummeted in value, yet Citron stuck to his strategy of borrowing against them and betting on the difference. His investment pool was eroded severely, thereby causing heavy losses.

4) Finally, what are the lessons to learn?

1. Organisations that invest long by borrowing short will definitely have to face liquidity risk.
2. A framework of investment policies, guidelines, and risk reporting and independent and expert oversight can help to impress risk-averse investors.
3. 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.
4. 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.