On December 6 1994, Orange County, a prosperous district in California, declared bankruptcy after suffering losses of around $1.6 billion from a wrong-way bet on interest rates in one of its principal investment pools. The pool was intended to be a conservative but profitable way of managing the countys cashflows, and those of 241 associated local government entities. Instead, ittriggered the largest financial failure of a local government in US history.
Robert Citron, the hitherto widely respected Orange County treasurer who controlled the $7.5 billion pool, had riskily invested the pools funds in a leveraged portfolio of mainly interest-linked securities. His strategy depended on short-term interest rates remaining relatively low when compared with medium-terminterest rates. But from February 1994, the Federal Reserve Bank began to raise US interest rates, causing many securities in Orange Countys investment pool to fall in value.
During much of 1994, Citron ignored the shift in the interest rate environment and the mounting paper losses in his portfolio. But by the end of 1994, demands for billions of dollars of collateral from Citrons Wall Streetcounterparties, and the threat of a run on deposits from spooked local government investors, created a liquidity trap that he could not escape.
Citron could not have undertaken such a risky investment strategy if his actions had been subject to informed and independent risk oversight, and detailed risk-averse investment guidelines. Following the debacle, Orange County revised many aspects of its controlprocedures and its financial governance, and established a stricter set of investment policies.
Orange County treasurer Robert Citron was no new kid on the block. He had been treasurer since 1972 and in early 1994, at about the time his investment strategy began to go sour, he survived an election that focused public attention on his financial management of the Orange County investmentpool. Citron managed to convince voters that the criticisms, which turned out to be close to the mark, were politically motivated.
Citrons strongest card was his track record. Earnings from the investment pool had been an increasingly important part of the Orange County budget since the late 1970s, leading to a relaxation of the rules surrounding how funds could be invested. In addition to thecounty itself, municipal entities such as the Orange County cities of Anaheim and Irvine, along with various local government authorities and services, were attracted to the investment pool by the unusually good rates of return it offered.
These investors put money that they raised from taxes and other sources into the pool, in the hope that the cash would grow before they had to spend it on vitalpublic services. Excess returns from the pool were particularly welcome in the early 1990s: the local political environment was set against raising taxes and local government finances were under increasing strain. Some municipal entities even began to borrow money to increase their pool investments. (According to some commentators, the excess returns over the years amounted to hundreds ofmillions of dollars and, in a limited sense, considerably offset the eventual loss.)
Few municipal investors in the pool quizzed Citron on how he worked his magic, or analysed independently the level of risk he was running to gain excess returns. They took comfort from the fact that Orange County was itself heavily invested in the pool. However, the board of supervisors that acted as the principaloversight for Citrons actions as Orange County treasurer lacked financial sophistication. Orange County also failed to surround Citron with a compensating infrastructure of strict investment policies, risk controls, regular and detailed reporting, and independent oversight. This mattered more and more as the aim of the pool gradually turned towards making, rather than managing, money.