The case of Orange County, California, 1994.

Orange County, California, USA, was the richest county in the US. It had to declare bankruptcy in 1994,
following losses amounting to USD 1.6 billion incurred in its investment portfolio. Post bankruptcy,
Robert Citron, the Treasurer acknowledged that he was “not as sophisticated as he thought he was”. In
the last county elections, he had been criticized for believing that “he can accurately anticipate the
market all the time, and also outperform everyone…..The incumbent has structured the portfolio …..on
the premise that interest rates would continue to decline”.

Clearly, knowledgeable professionals were aware of the risk in the portfolio. If Citron’s superiors in the
County Government refused to control his freedom, it was because of his performance over earlier
years, when he had consistently earned above market returns. IN retrospect, it is obvious that above
average returns could have been produced only by adopting risky strategies, which did bring in the
money for a few years.

The two strategies, in the Orange County Case which went wrong in 1994 and led to the bankruptcy of
the county were –

1) Citron was borrowing short term and investing in the bond market,
2) He added to the risk of the portfolio by investing in the so called Inverse Floaters, where the
coupon is, say, 10%-LIBOR, which means that the inflows will go up if LIBOR falls and vice versa,
which was clearly a bet on falling interest rates,
3) He leveraged the portfolio through large and repeated REPO transactions so that its effective
duration was significantly higher than the portfolio’s maturity! (For a coupon security, the
duration will always be less than the maturity; equal to maturity for a zero coupon bond).
4) The mechanics was somewhat as under – Start with A USD 100 million bond investment. If you
undertake a REPO – security repurchase, or a sale and buy back transaction at different prices to
reflect interest on the funds lent – you receive say USD 100 million which can once again be
invested in another bond, and so on. It must be noted that in REPO transactions, the
counterparty is really giving a short term loan secured by the bond; and the lender has the right
to ask for a margin, or failing that, to sell the bond, should the price fall.

All the three strategies were bets on continued fall in interest rates. When rates started going up,
for a while, Citron increased the risk further in order to, hopefully, recoup the losses! As rates kept
rising, however, the County went bankrupt.

Subsequently, the County sued the various bankers who were counterparties to the transactions, as
also KPMG, the County’s auditors. Most of the cases were settled out of Court. Merrill Lynch, the
principal banker to Orange County ended up paying USD 400 Million and KPMG and CSFB also paid
out substantial sums. Overall, Orange County managed to recover something like USD 800 Million
from the various parties. Citron was jailed for a year for securities fraud.
Incidentally, in what is perhaps a unique event in the history of credit rating, Orange County also
sued Standard & Poor, the well-known credit-rating agency, for damages of USD 2 billion, for giving
the county too high a rating! The case was dismissed in June, 1999.

The two important risk management lessons that emerge from the Orange County Case are –

1) The first is that views can go wrong and there are obvious risks in borrowing short and lending /
investing long term. Such bets have to be limited to the entity’s loss absorbing capacity.
2) The second is that, a fund manager reporting above average returns should be supervised and
his activities scrutinized with more than ordinary care, a lesson equally applicable to the case of
Leeson and Barings. Moreover, an overconfident dealer, who “knows” what the market will do,
and not subjected to rigorous risk management parameters, can be very dangerous to his
employer!

There is also a lesson for the commercial and investment bankers here who were counterparties to
the transactions, and paid out huge sums of money to the County in subsequent legal proceedings,
which is the importance of “appropriateness of transactions”.