Debacle Will Cost Every City, Town in the Nation

Behind Orange County’s unprecedented bankruptcy filing lies a pattern of sheer, loopy amateurism and intellectual dishonesty.

With little of the oversight or controls that are common to corporate finance or the management of any mutual fund, Orange County’s treasurer managed to turn $7.5 billion in public tax revenues--put in his care to earn short-term interest--into bankruptcy on a fund totaling almost $20 billion.

The filing under Chapter 9 of the federal bankruptcy code is tactical, intended to shield the county’s fund from redemptions and lawsuits by some of its 187 investors, which include cities, school districts and transport and sanitation agencies in the county.

But it’s a tactic that will have long-term consequences for every city, town and school district in the United States. Simply put, they will have to pay more to borrow money from now on.

“This turns the world of municipal finance upside-down,” says the head of a Los Angeles municipal bond firm. “It changes the view of investors toward municipal debt. If issuers can consider bankruptcy as an alternative, then it raises the level of risk for all.”

How did proud Orange County come to this? It’s yet another case of “We have met the enemy, and he is us.”

Right now, the county faces a threat of $1.5 billion in losses in a fund of only $7.5 billion of public money. But that public tax money was leveraged almost threefold by $12 billion in borrowings designed to enhance the returns on investment--the more you invest, the more you can earn, or lose.

And what was the public purpose of those borrowings? It was to give county agencies, cities and school and water districts a little extra in their budgets. That way, government officials and county residents could get around the realities of life in a time of stern voter resistance to taxes and vocal protests about the size of government.

Orange County is not alone. Across the United States, municipalities have been piling on debt for years even as Americans have crowed about shrinking government. State and local government borrowings rose to $289 billion last year from $154 billion in 1991, according to the Federal Reserve System, although rising interest rates have cut the number of bond issues this year. Total municipal debt outstanding has risen to $1.22 trillion from $365 billion in 1980.

“Orange County is only unique in the amount of leverage,” says Joe Mysak, editor of Grant’s Municipal Bond Observer, a biweekly newsletter. Municipalities in other states, from Florida to Wyoming, have come to grief in complex investments involving interest rate swaps and other financial derivatives.

But Orange County is unique as the largest political entity ever to declare bankruptcy--New York in 1975 never got to bankruptcy, and a judge turned down the 1991 filing by Bridgeport, Conn.

Blame it on the incredible amateurishness with which County Treasurer Robert L. Citron was allowed to manage the vast portfolio of tax revenues. Even as the fund declares bankruptcy, public finance officers in California and elsewhere have many unanswered questions.

“Who authorized Bob Citron to borrow that much?” asks a public finance expert. “Was it the supervisors?” Citron ran a peculiar operation, trading billions in bonds himself, says a bond dealer who knows him.

Citron’s basic investment approach was not complicated. He reasoned that longer-term investments paid higher interest than short-term ones, so he used interest rate swaps and other financial techniques to “lengthen the portfolio’s duration,” explains Robert Haugen, a professor of finance at UC Irvine.

Orange County’s fund investments attained an average maturity of 2 1/2 years and thus earned higher interest. And that return was then enhanced by using borrowed money to increase total investment.

The fatal flaw in Citron’s approach didn’t really show up until this year, as interest rates rose. Values of bonds and notes in Orange County’s fund fell, as did those of most bond funds. But unlike mutual and pension funds and prudent corporate treasurers, Citron was not required to revalue his investments daily to reflect market conditions.

Citron’s reports to the county’s five-member Board of Supervisors, in contrast, were chatty reviews of the economy. In this year’s report, he included an observation that “governmental accounting standards do not require municipal investment pools to periodically adjust the cost of their portfolios to reflect current market.”

So the supervisors apparently were not aware of the extent of the fund’s problems. And oversight by the debt-rating agencies, Standard & Poor’s and Moody’s, proved a joke. Consistently, their reviews of Orange County debt focused on the area’s underlying economic strength and praised the high returns Citron’s fund was making--without questioning how he was making them.

Such lax regulation is about to change. “There will be much more scrutiny of municipal debt,” says the head of a bond firm.

The role of Wall Street houses in Orange County’s failure will receive attention in a Securities and Exchange Commission investigation and in congressional hearings and lawsuits in the months ahead. Merrill Lynch loaned Orange County $2.5 billion and then supplied the investment vehicles in which Citron put the money.

The whole thing, in short, looks less like a professionally managed investment fund than a political slush fund. And in truth, that is partly what it was, not in the traditional sense of graft, but in the contemporary sense of office holders under pressure from rising costs and angry voters trying to get a little leeway.

Who will pay for the mistakes? The people of Orange County will pay, either with more cash to support their stricken communities and school districts or in reduced services. And every other county, town and city will pay too, because amateurism and intellectual dishonesty have just raised the level of risk for all.

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