Corporate Finance
The Orange County Financial Crisis: Risk and Excessive Returns
Wentworth, Hauser and Violich
Wentworth, Hauser and Violich
Editors' note: The financial crisis in Orange County has raised many questions about the credit worthiness of Municipal Bonds and other tax exempt investment vehicles. Stellar Online offers this succinct analysis by a highly respected investment firm:
Orange County managed, through its Treasurer, an investment pool that was the temporary repository of the proceeds of municipl bond offerings. The fund was also the temporary repository for tax and other revenue collections from Orange County and the various municipal agencies within the County. Other municipalities and agencies within the state of California also invested their surplus or working capital funds in the Orange County pool. The state of California manages a similar investment pool, called the Local Agency Investment Fund (LAIF), as do a number of other counties throughout the state.
Robert Citron was elected Orange County Treasurer in 1973. He modernized the office by upgrading his investment management tols and developed software programs to forecast and match the maturities of fixed income investments and revenue collections to the cash requirements of the county and state agencies. Interest earned on the investment portfolio became an increasingly important part of the county budget, particularly after 1978 and the passage of Proposition 13 limited the base and increase in property taxes.
Mr. Citron petitioned the state to liberalize and expand the investment powers of county treasurers. His efforts were successful. As a result, Mr. Citron began to use riskier investment instruments, including derivatives and arbitraged interest rate spreads by th use of repurchase agreements.
Additionally, the county investment pool borrowed funds short-term to invest the proceedings in longer maturity bonds with the expectation that investment returns would exceed the borowing costs. The borrowed funds or margin approximated $12.5 billion on the $7.5 billion of invested funs in the pool.
Mr. Citron's investment strategy was based on a continuing decline in interest rates. When interest rates turned upward in the fall of 1993, the protfolio began to experience losses as the market prce of interest-rate sensitive securities in the portfolio fell. In a stubborn blief that interest rates would not rise any further, despite repeated signals to the contrary by the Federal Reserve, Mr. Citron continued to leverage the portfolio and resisted liquidating interest-rate sensitive securities. As th investments continued to decline in value, margin calls were triggered forcing the sale of portfolio assets. On December 6, 1994, the county declared bankruptcy. Investment losses are estimated at $2 billion or about 26 percent of the $7.4 billion portfolio.
The lesson of Orange County is that risk accompanies excessive returns. Investors should assume risk with equity investments not fixed-income investments.