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The Orange County bankruptcy was described as the largest municipality that ever filed bankruptcy in the United States’ history. The bankruptcy was brought forwards by Robert Citron who was then the treasurer-tax collector and controlled various Orange County funds including the Investment Pool, General Fund and Treasury Commingled Fund. In 1994, the Orange County Investment Pool had approximately $7.6 billion in deposits; these funds were from the County’s government and estimates of 200 local agencies. Out of the 200 local agencies, some were mandated to invest their finances in the Orange County Investment pool (Baldassare, 1998).
At the time, there was significant opposition towards any attempt to raise taxes while County services were in high demand. Consequently, Citron strategized to make investments with the aim of earning the County’s numerous incomes. Hence, as the County’s financial controller, he took a significantly leveraged position with the use of floating rate notes and repurchase agreement (Public Policy Institute of California, 1998).
Citron’s strategy was to use the deposited funds as collateral in borrowing money to invest in high-yield long-term bonds, derivatives and inverse floaters. In order to attain the level of leverage of amounts ranging from 158% and exceeding 292%, Citron placed the County’s treasury bonds as collateral to the borrowed funds. Consequently, the County’s Investment Pool increased to $20.6 billion since for every $1 on deposit he borrowed $2 (Baldassare, 1998). Essentially, he borrowed short to go long and invested the funds in securities whose expected yields were inverse to the existing interest rate.
In a short while, the County’s funds gained excessive returns on investments; however, Citron began to hide the excess returns. This was achieved through transferring funds from the County’s general fund to the Treasury Commingled Fund, a fact that he admitted in court; in spite of this, the County’s financial position was not doubtful until February 1994. The United States Federal Reserve Bank began to raise the interest rates leading to a significant number of securities held by Orange County to depreciate (Johnson, 2010). As a result, Credit Suisse First Boston (CSFB) discovered the County’s financial position and subsequently blocked any extension for the issuance of repurchase agreements at the new applicable interest rate.
On November 1994, auditors disclosed that Citron had lost the County’s $1.64 billion; consequently, it was discovered on December 1994 that the County did not have sufficient funds to survive a run for the money by local pool depositors and Wall Street investors. This led to the collapse of the County’s finances and subsequent unsuccessful attempts to dispose the risky securities (Public Policy Institute of California, 1998). The County’s creditors threatened legal action and repossession of the County’s Pool securities, which were held as collateral. When the first bank took this position and reposed the County’s securities in its custody, Orange County’s government declared bankruptcy (Baldassare, 1998).
In the event that the organizational planning, risk and structure’s oversight mechanisms are fractured, it is significantly easy for malicious parties to compromise institutional integrity. The concept of short borrowing and long investing entails significant liquidity risks. Therefore, risk-averse investors must link investment decisions and actions to investment objectives through the implementation of a stringent framework entailing investment guidelines, risk reporting, policies, expert and independent oversight (Johnson, 2010). In light of this, risks should be analyzed and reported comprehensively; furthermore, County’s governments should preserve high accountability standards and fiscal oversight.
The state of California should review and re-evaluate the structure and integrity of its County’s financial management and oversight. Therefore, State governments should monitor the fiscal environment of their respective local governments instead of waiting for issues to arise. Consequently, County officers should not be allowed to make significant resolutions, such as investment and financing decisions, independently. Short-term fiscal policies should be handled carefully and with comprehensive consultation with relevant parties in order to avoid investments that might backfire since it leads to numerous losses, as was the case in Orange County.
- Baldassare, M. (1998). When government fails: The Orange County bankruptcy. Berkeley, CA: University of California Press.
- Johnson, S. R. (2010). Bond evaluation, selection, and management. Hoboken, NJ: John Wiley & Sons.
- Public Policy Institute of California. (1998). When government fails: the orange county bankruptcy, a policy summary. Sacramento, CA: University of California Press.