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sense, considerably offset the bearing securities would maintain

eventual loss.) or increase their value. He used var- Timeline of
Few municipal investors in the ious techniques to leverage his $7.5 events
pool quizzed Citron on how he billion of funds into more than $20
worked his magic, or analysed billion of investments so that both February 1994: Fed makes the first
independently the level of risk he the returns and the risks were multi- of a series of interest rate hikes,
was running to gain excess returns. plied. and so threatens the directional
They took comfort from the fact One way he did this was to enter bet on interest rates built into the
that Orange County was itself into contracts known as reverse Orange County investment pool.
heavily invested in the pool. repurchase agreements, which September 1994: Orange County
However, the board of supervi- allowed him to use securities the treasurer Robert Citron tries to calm
sors that acted as the principal pool had already purchased as growing fears among investors.
oversight for Citron's actions as collateral on further borrowings, November 1994: Auditors find that
Orange County treasurer lacked and further cycles of investing. But the pool has massively lost value.
financial sophistication. Orange these agreements left him vulnera- December 1, 1994: Citron confirms
County also failed to surround ble to calls for more collateral if the that the pool faces $1.5 billion loss.
Citron with a compensating infra- market value of the original collat- December 3, 1994: Citron resigns.

structure of strict investment poli- eral fell. December 6, 1994: Prompted by
cies, risk controls, regular and due date of certain repo
detailed reporting, and independ- transactions, Orange Country files
ent oversight. This mattered more Citron used various for Chapter 9 protection.
and more as the aim of the pool techniques to leverage his May 2, 1995: US Bankruptcy Court
gradually turned towards making, endorses settlement of what is left
rather than managing, money. $7.5 billion of funds into in the investment pool. Some 241
Through the early 1990s, Citron more than $20 billion of participants get 77 cents in each
enjoyed his growing importance as dollar of their investment balance
someone who conjured up extra investments so that both as a cash distribution.
money for public services. The the returns and the risks November 19, 1996: Citron is
amount of public money in the sentenced to a year in jail and
pool grew quickly until in 1994, were multiplied’ $100,000 fine.
Citron was investing $7.5 billion in US December 17, 1997: Moody's
agency notes of various kinds. He Investors Service rewards the
was a popular port of call for sales- Citron also used around $2.8 bil- county's recovery and new
men from Wall Street's big broker- lion of structured notes, or deriva- investment policies with an
age firms, particularly those from tives, to increase his bet on the investment grade rating for key
securities giant Merrill Lynch. Later, structure of the interest rate yield county borrowings.
these salesmen would say they curve. These included many June 2, 1998: Orange County
were merely servicing an experi- “inverse floaters” – notes whose reaches a $400 million settlement
enced and savvy investor, while coupon falls as interest rates rise – of its lawsuit against Merrill Lynch.
Citron would claim he had been as well as index amortising notes February 25, 2000: Some 200
misled about the riskiness of the and collateralised mortgage obli- municipal and governmental
instruments. gations. agencies finally made good in a
One thing is certain: while the The relative complexity of the disbursement of $864 million. But
pool offered greater returns than instruments, the daisy-chain struc- Orange County continues to pay
those of similar cash management ture of the portfolio and Citron's lim- off the recovery bonds it issued in
pools, it did so only by taking on ited financial reporting made it dif- 1995/6 to fund the bulk of the
more risk. In particular, Citron gam- ficult for independent critics to pool’s losses.
bled that medium-term interest- understand or prove how risky the

June 2001

strategy really was. But the end That agreement proved elusive, attracted risk-averse funds in the
result is clear: the pool transformed and Wall Street institutions began to first place.) But it is wrong to blame
short-term funds intended for vital sell off the securities they held as one individual. The risk managers of
public services into a risky and collateral against their agreements Canadian investment bank CIBC
leveraged investment in medium- with Orange County. The Orange recently compared the Orange
term financial instruments. County Board of Supervisors took County failure to that of Barings
As long as short-term interest legal advice and declared bank- Bank, pointing out that in these oth-
rates remained low, as they did in ruptcy on December 6, a move erwise very different debacles, “the
the early 1990s, Citron’s bet on the that prevented investors withdraw- man in charge showed excellent
relative value of medium-term ing any more of their funds. It also results at first, and was therefore
interest rate-linked securities paid set the scene for a public auction allowed to transact without proper
off and all concerned prospered. of Citron’s investment portfolio so surveillance or controls” (Crouhy et
The strategy soured with a shift in that the proceeds could be rein- al, 2001). Orange County is prima-
policy by the Federal Reserve in vested in safe, and liquid, short- rily a story of what happens when
February 1994. That month saw the dated government stock. the desire for excess returns over-
first of a succession of hikes in inter- By January 19, with this restructur- rides risk oversight.
est rates that ultimately saw the Fed ing completed, Orange County’s

The aftermath
Citron eventually pleaded guilty to
Citron exposed a set of conservative investors with six felony counts. However, the
specific funding needs to a risky portfolio. He failed to charges were largely to do with a
misallocation of returns between
communicate the extent of the market risk, or liquidity the county and other municipal
risk, to either the investors or to his supervisory board – entities, and Citron does not seem
to have been motivated by per-
though he did not hide the fundamentals of his strategy’ sonal gain of any direct and obvi-
ous kind. He paid a $100,000 fine
raise rates by some 2.25 per cent financial firestorm was over – but its and spent less than a year under
over the course of 1994. By Nov- losses had crystallised at around house arrest.
ember, the investment pool was in $1.69 billion. Some expert commen- If that seems a lenient sentence,
crisis as the value of its interest rate- tators have argued that it could then Orange County’s recovery
sensitive medium-term investments have cut this bill if only it had had was also swifter than might have
sank, and calls for more collateral the nerve to hang onto some of been expected. It had to cut back
arrived from Wall Street. Citron’s investment portfolio. on spending and social service pro-
Citron’s counterparties prepared But this makes little difference to vision, and in 1995 and 1996 it took
to seize and liquidate billions of dol- the fundamental lessons to be on massive additional debt in the
lars of the investment pool’s collat- learned from the debacle. Citron form of special long-term “recovery
eral, while the government entities exposed a set of conservative bonds” to cover its losses. But
that had invested in the fund, lack- investors with specific funding thanks to increased tax revenues
ing credible reassurances, looked needs to a risky portfolio. He failed from a buoyant local economy, it
to withdraw their money. On to communicate the extent of the was able to exit from bankruptcy in
December 1, Citron admitted the market risk, or liquidity risk, to either only 18 months.
fund had lost around $1.5 billion or the investors or to his supervisory With new executives in charge, it
around 20 per cent of its value. He board – though he did not try to instituted a series of governance
resigned on December 3, as hide the fundamentals of his strat- structures and reforms. These
Orange County officials desper- egy. (Had he properly assessed included oversight committees, an
ately tried to work out an agree- and communicated the level of internal auditor who reported
ment with their Wall Street creditors. risk, the pool would not have directly to the supervisors, a com-

June 2001

mitment to long-range financial of the settlement that it had acted finally made good. In February
planning and a stricter written pol- “properly and professionally in our 2000, officers appointed by the
icy for investments. In December relationship with Orange County”. It courts paid out around $864 million
1997, Moody’s Investors Service cited the costs, distraction and to various government entities that
rewarded the county with an uncertainty of further litigation as had suffered from the collapse. Five
investment grade rating for key the reason it had come to make years on from the bankruptcy, it
borrowings. such an expensive settlement, was a big day for the smaller credi-
The new Orange County invest- while assuring its investors that it tors. But on the same day, Orange
ment policy statement establishes had already fully reserved against County supervisor Jim Silva
safety of principal, and liquidity, as such an outcome. reminded local reporters that the
the primary objectives of the fund, Together with settlements from county itself was still paying off
with yield as a secondary objec- more than 30 other securities some $1.2 billion of the recovery
tive. More specifically it prohibits houses, law firms and accountancy bonds issued in 1995 and 1996 –
borrowing for investment purposes firms that the county held partly and would be for several decades,
(ie, leverage), reverse repurchase responsible for the losses, the unless it was able to speed up
agreements, most kinds of struc- money from Merrill Lynch meant repayments. I
tured notes (such as inverse that some 200 municipal and gov- Rob Jameson is reference editor
floaters) and derivatives such as ernmental agencies could be at ERisk
options. The same document bans
the treasury oversight committee Resources and References
and other designated employees
from receiving gifts, and obliges Mark Baldassare, When Government Fails: The Orange County
them to disclose economic interests Bankruptcy, Public Policy Institute of California and the University of
and conflicts of interest. The county California Press, 1998. Overview available here.
treasurer now has to submit
monthly reports to the investors and Steven Cohen and William Eimicke, Is Public Entrepreneurship Ethical?:
other key county officers that “con- A Second Look at Theory and Practice, see section on “The Financial
tain sufficient information to permit Collapse of Orange County”, which discusses the high regard in which
an informed outside reader to eval- Robert Citron was held before his fall from grace.
uate the performance of the invest-
ment programme”. Michel Crouhy, Dan Galai and Robert Mark, Risk Management,
On June 2, 1998, Orange County McGraw-Hill, 2001, page 34, available through
reached a massive $400 million set-
tlement with Merrill Lynch, the firm it Richard Irving, “County in Crisis”, Risk, March 1995, pp 27–33.
held most responsible for steering
Citron towards what the county Philippe Jorion and Robert Roper, Big Bets Gone Bad: Derivatives and
deemed risky and unsuitable secu- Bankruptcy in Orange County, Academic Press (1995), available
rities. Thomas Hayes, who led the through
county’s litigation, said he
regarded the settlement as fair Philippe Jorion’s Internet case study: “Orange County Case – Using
while Janice Mittermeier, Orange Value-at-Risk to Control Financial Risk”
County CEO in its recovery period,
said the resolution “assures county Orange County press release, “Bankruptcy Court Will Hear County's
taxpayers that those responsible for Case Against Investment Broker Merrill Lynch”, December 1, 1995
the losses that caused the county’s
bankruptcy are being held Russ Banham, “Local Hero”, Treasury and Risk Management
accountable”. Magazine, October 1998
Merrill Lynch maintained as part

June 2001