The orange county, a municipality in United States was declared bankrupt on 6th December 1994 after loosing about $1.6 billions due to risky investment strategies i.e. over leveraging purchases of structured notes and fixed income securities.
Robert Citron who was the county treasure gambled with $7.5 billion public pool with a strategy of borrowing short to go long. Being a star performer he wanted to raise higher income without increasing the taxes, as he believed that medium term investments had higher returns than short term investments. Citron entered into reverse repurchase agreement where he used the pool’s securities as collateral to invest further on new securities, he leveraged derivatives securities like inverse floaters, collateralized mortgage and index amortizing notes to increase the interest rates. He riskily invested the pool’s Portfolio as he didn’t have knowledgeable and autonomous risk oversight committee which could understand the investment objective of the county, as (Jameson, R.,2001) states that the board which was his principal advisor had no financial prowess in risk control to evaluate the probability of interest rate, credit, exchange, prepayment and price risks occurring. They also failed to formulate for him sustainable investment policies or make consistent progress report to help risk-averse investors in integrating investment objectives and sustainable investment actions.
The strategy for $7.5 billion portfolio worked fine as long as interest rates went down leveraging into more than $20 billion dollar position amplifying the returns, the investment pool went into cash crunch in November 1994 when Federal Reserve Board increased the federal interest rates by 2.25% amplifying losses. Citron acknowledged the loss of approximately $1.5 billion forcing him to resign as county chief executive officer and to protect Orange County from creditors like Wall Street firms, the supervisors took legal advice liquidating Orange County as the loss was too big to control .Citron later pleaded guilty to six felony counts along side other charges like filing a false and misguiding financial summary to stakeholders in purchasing securities in the county investment pool. He was fined a $100,000 and put under house arrest for a period nearing one year.
The orange county recovered from liquidation when the former state treasurer Thomas Hayes was called upon to mange the pool. He set up management mechanisms which allowed emergency withdrawals by local governments. Board of supervisors appointed a crisis team and new chief executive officer who came up with recovery strategies like; downsizing staff to reduce budget spending and social service provisions, removing staff officials who were badly reputed, dividing remaining investment pool between pool investors and county government, diverting tax fund collected from other county agencies to pay other vendors or bond holders, paying debt on prevailing bonds, paying off liquidation litigation and refinancing other bonds. They were also instrumental in reforming and restructuring investment governance e.g. constituting new oversight committee, enhancing internal audit and stringent investment policy primarily aiming at safety principles of liquidity seconded by yield. The investment policies also prohibited leveraging, reverse repurchase agreement and structured notes. Another financial recovery plan was the acceptance of bond investors to roll further county’s debts in exchange for higher interest rate,
Short term borrowing for long term investment can easily become bankrupt and should never be a sole decision of an individual due to high risks involved but independent credible oversight committee which can articulate investment policies, directives and risk control strategies like application of value at risk to ensure that those who irresponsibly invest public funds are held accountable.
References
Jameson, R. (2001).ERisk.com Case Study: Orange County. Retrieved from http://content-bus.kaplan.edu/GF560_1107D/images/product/GF560-02-09-JA.pdf
