O.C. FINANCIAL CRISIS : The Downfall of a High-Risk Fund : Repurchase Agreements Focus of Controversy Over Strategy


At the end of October, Orange County Water District Treasurer Andrew Czorny got a directive from his board: Look into alternatives to keeping the district’s $110-million rainy-day fund in the county investment pool.

The board’s unease over its money--90% of its investment portfolio--was understandable. By then, the pool managed by Orange County Treasurer/Tax Collector Robert L. Citron was earning about 6% a year, with a fantastically high degree of risk. Meanwhile, six-month Treasury bills, about the safest investments around, were offering almost as much return.

On Oct. 31, Czorny asked Assistant County Treasurer Matt Raabe whether the county could cover a withdrawal. Raabe assured him the pool had $2 billion in liquid assets--enough to cover a withdrawal by every one of the more than 70 local agencies that voluntarily place their funds with the county. (Another 110 have no choice but to invest through Citron’s office.)


But this week Raabe changed his tune.

Brokerages that lent the county more than $12 billion had demanded additional collateral of as much as $1.6 billion, leaving the pool with what officials said Friday was only $350 million in liquid assets.

On Thursday, the county announced that the $18.5-billion investment pool had suffered $1.5 billion in so-far unrealized losses--by far the biggest investment loss disclosed by any local government anywhere during this year of turmoil in U.S. financial markets.

The disclosure has sharply focused public attention on Citron’s investment strategy, which was aimed at profiting from declining or stable interest rates. Why, observers wondered, did Citron not change course last year--or at least earlier this year, when interest rates were clearly fixed on an upward course?

In fact, Citron’s risk-oriented approach to investing public funds was no secret among the 187 municipalities and public bodies that entrusted their tax revenues and other income to him.

As recently as Sept. 26, in an informal report to the county Board of Supervisors, Citron wrote: “We continue to use reverse repurchase agreements as part of our investment strategy.”

Those so-called “reverse repos”--recognizably risky transactions in which the fund borrowed against its holdings in hopes of multiplying its returns as interest rates fell--were the secret to Citron’s supercharged investment yields.


But they also bore the seeds of their own downfall, for they are too complex to reverse quickly in the event the market changes course. And that’s what happened: The Federal Reserve Board has been pushing interest rates higher most of this year.

Citron “had a strategy that made an awful lot of money, but he didn’t modify his strategy,” says Peer Swan, treasurer of the Irvine Ranch Water District, another investor in the county pool. In fact, Swan says, increases in interest rates after April this year may have made it impossible to unwind many of the more complex transactions without recording a loss.

Put simply, a reverse repo is a deal in which the owner of a security uses it as collateral to borrow money and then invests the borrowed money in another security.

In times of declining or stable interest rates, the strategy is a great money maker.

The owner of a $1-million, five-year Treasury note paying 6%, for instance, uses it as collateral to borrow another $1 million, which he then invests in another $1 million Treasury note, also paying 6%. If he pays 4% interest on the loan, he has increased his investment yield from 6% to 8%--the combined yield of the two $1-million notes, minus the 4% loan cost.

In fact, as Citron noted in September, his reverse repos added an additional 2% to the return on the county pool. By the end of November, the pool had $12.9 billion in outstanding reverse repos.

But Citron evidently could not move fast enough when interest rates began to turn up.

In that environment, the reverse-repo strategy squeezes the investor in two ways. The cost of the borrowed money rises, reducing the investment gain, and the value of the collateral drops--provoking precisely the collateral calls that drained the county pool of cash this year.


Citron’s inability to unwind his borrowings may have been exacerbated by his resolutely upbeat view of the future course of interest rates.

In the same September report, he argued that the national economy was likely to slow down next year; if so, interest rates would slide back down. Although that viewpoint was by no means uncommon in the nation’s capital markets, it evidently kept Citron from adopting a more defensive investment posture.

Citron consistently bet big on lower rates. Among other securities in the portfolio, according to a preliminary study by Capital Market Risk Advisors, the New York firm hired to analyze Citron’s investments, are as much as $8 billion in “inverse floaters.” These are securities designed to rise in yield as interest rates decline--and decline as interest rates rise.

Other local governments--along with large companies, institutional investors and many bond investors--have been nipped by the upward turn in interest rates.

“I think what’s happened in the environment of low interest rates and an inability to raise taxes (is) that they’re looking for a way to generate revenue . . . by going for the higher yields,” said Betsy Dotson, assistant director of the Government Finance Officers Assn., a nonprofit professional group in Washington.

Sorting out the Mess

A risky investment strategy has thrown Orange County’s once high-flying investment fund for local government agencies into turmoil. The fund’s challenge: to keep agencies from pulling out, which would force fire sales of securities and balloon Orange County’s losses.



Orange County used financial instruments called reverse repurchase agreements to borrow against its $7.5 billion in investment holdings, leveraging the fund up to more than $20 billion. Here’s how reverse repos work:

1. The owner of a security--a $1-million, five-year Treasury note with a 6% coupon, for example--pledges the note to an investment bank as collateral for a $1-million loan.

2. The investor then uses the loan to purchase another $1-million, five-year note earning 6%.

3. Assume the investor is being charged for the loan at an annual rate of 4%. If interest rates remain stable, then his yield on his $1 million--originally only 6%--is now 8%: 6% plus 6%, minus 4%.

4. Here’s the risk: The investor is borrowing short-term; reverse repo transactions generally have a term of 30, 60, or 90 days, at which point they are routinely rolled over. But the investor is using the money to buy long-term investments. If interest rates shoot up, as they have this year, he gets squeezed twice:

A. The value of his collateral--the original $1-million note--drops, so his lender demands cash or more securities to make up the difference. Since August, Orange County has had to add $650 million in collateral with rising interest rates.


B. The rate charged by the bank on the loan rises as the loan is rolled over. If rates rise quickly enough, the cost of the loan may rise above the return on the investment.


The five largest investors in the Orange County fund have committed more than $2.25 billion. Their investments, in millions of dollars:

Orange County Transportation Authority: $1,000

Orange County Sanitation District: $450

Transportation Corridor Agencies: $306

Irvine Ranch Water District: $300

City of Irvine: $196

MAN ON THE SPOT Robert L. Citron’s performance as Orange County treasurer-tax collector has come under fire with the disclosure of substantial reversal’s in the county’s investment fund. Some background on Citron: * Age: 69 * Residence: Santa Ana * Salary: $100,339 a year. * First elected: Won election as Orange County tax collectro in 1970. Became treasurer in 1973 when the Board of Supervisors combined the positions. * Politics: The only Democrat holding elective office in Orange County government. Ran unopposed between 1970 and 1994. * ’94 Challenge: John Moorlach, a certified public accountant and financial planner, ran against Citron, criticizing his management of county funds as too risky. Citron won with 61.1% of the vote in the June 7 election.

Sources: Orange treasurer-tax collector; Times reports