The Federal Reserve Board kept raising interest rates throughout 1994 and Citron was buying more securities with a hunch that the Fed would lower rates at the end of the year. The investment strategy was based on a continuing decline in interest rates. When the interest rates turned upward in the end of 1993 the investment portfolio began to experience losses as the market price of interest rate sensitive securities fell.
Contrary to the advice of Federal Reserve the portfolio was leveraged and interest rate sensitive securities were not liquidated in a belief that interest rates would not rise any further. The situation was exacerbated by the use of reverse repos. A repurchase agreement or repo is an instrument for investing money while a reverse repo is a means for a government to borrow against securities that it holds. The instrument is a form of temporary debt for the issuer.
Orange county used reverse repos to obtain additional money that was used in turn to purchase additional risky instruments. Subsequently, the Governmental accounting standard board used interpretation No: 3 Financial Reporting for Reverse Repurchase Agreements which is intended to force governments to disclose their dealings in reverse repos and presumably rein in their use. By November 1994 the county officials found out that $1. 64 billion were lost in government funds through these risky investments.
As the investments continued to decline in value margin calls were triggered forcing the sale of the assets. Taxpayers were asked to foot the bill but they were not the only victims in the county bankruptcy. Independent rating agencies were also taken by surprise. Orange 4 When the Wall Street lenders and local government depositors wanted the money the county officials did not have cash on hand. The banks that had lent to the county threatened to seize the securities from the county pool that they had head as collateral.
The county government declared bankruptcy after the first bank took this action. The bankruptcy prompted all local government depositors to withdraw the money. The county’s credit rating immediately fell to “junk status” and the Wall Street firms continued to sell off the millions of dollars in securities that they held as collateral. While financial leverage and the use of derivatives might be acceptable for high risk portfolio managers a gambling strategy has no place in cases involving public money.
Tom Hayes a former state treasurer was called in to manage the county pool. He set up a mechanism allowing the local governments to withdraw some of the funds from the pool on emergency basis. The county presented its recovery plan to the U. S bankruptcy court in Dec 1995 a year after its Chapter 9 filing. In June 1996 the government sold the $880 million bonds needed to pay off the debts. The Orange county bankruptcy finally ended on June 12 1996. The orange county debts were the result of leveraging the county funds to buy risky securities to create more interest income.