Orange County, California the home of Disneyland and the fifth largest county in the United States experienced a painful lesson in the risks of investing when it filed for bankruptcy protection in 1994. Orange County a prosperous district in the state of California declared bankruptcy with losses up to $1. 6 billion. It is the largest municipal bankruptcy in U. S history. Robert Citron the treasurer who along with a five member board of supervisors invested huge amounts of money.
The board of supervisors had no knowledge of the financial competency of the investments made and nobody questioned Robert Citron about it as he had the reputation of getting high returns for the county. The five member governing body did not exercise their supervisory duties. They turned a blind eye to the risky investments. Speculation, authority, lack of documentation and suitability of investment are cited as the main reasons for failure. Risky investment instruments including derivatives and arbitraged interest rate spreads using repurchase agreements were the prime cause of the crash.
Short term borrowings were done to invest in longer maturity bonds with the expectation that investment returns would exceed the borrowing costs. Orange 2 By 1994 Citron had gathered about $7. 6 billion in deposits from the county government and 200 local public agencies. He had a track record of providing high interest income to his local government investors. Citron boasted “We have perfected the reverse repo procedure to new levels”. (Baldassare 2) He did this by borrowing money and investing it in derivatives, inverse floaters and long term bonds that paid high yields.
Heavy investments were placed on derivatives which are gambles on what will happen on the interest rates. When rates went in the opposite direction than expected the county was in trouble. Citron borrowed more money with the borrowed money. By 1994 the size of the portfolio had increased to $20. 6 billion as he borrowed $2 for every $1 on deposit. He took more risks to raise more interest income for local government that was already facing a crisis with low tax collections. As paper profits started rolling in during the good years responsibility took a leave and with it accountability.
Citron started buying inverse floaters for Orange county in 1991 because he bet interest rates would fall. In the early 1990s he was getting such good returns on his risky instruments that public authorities such as the city of Irvine Water authority issued a short term investment pool. With the profits came greed. To make even bigger bets Citron leveraged his $7. 5 billion portfolio borrowing to the point that he controlled a total of $21 billion in paper assets. Much of the difference of $14 billion was made through reverse repurchase agreements.