ORANGE COUNTY IN BANKRUPTCY : Citron Borrowed Billions More as Interest Rates Rose : Finance: As ex-treasurer pursued ill-fated strategy, portfolio’s debt rose. Questions on securities raised.
Former Orange County Treasurer Robert L. Citron sharply ratcheted up his bet that interest rates would fall by adding $3.2 billion in borrowings to his highly debt-laden portfolio between February and April this year, according to public documents and interviews with market observers.
Instead, that very period saw rates undergo one of their steepest climbs in history, cutting the heart out of Citron’s strategy and rendering many of the exotic securities he had bought with borrowed money unmarketable.
A Times analysis of the Orange County investment pool’s portfolio shows that the amount of “leverage,” or borrowing to finance securities purchases, climbed to a peak of $16 billion in April this year from $12.8 billion in February, before dipping back to about $13 billion at the end of November.
While the fund borrowed, it was redoubling its bets on a fall in interest rates. The ratio of “structured notes”--securities fashioned to benefit from such a decline--rose from 15% of the portfolio at the end of March, according to sources, to $8 billion, or about 47%, just before the fund was frozen by the county’s bankruptcy filing.
Also, the portfolio analysis suggests that after Feb. 1 Citron bought $1 billion or more in one particular kind of structured note.
Furthermore, the Times’ analysis raises questions as to whether the county’s list of securities holdings is even accurate. The official inventory of holdings as of Nov. 23 lists at least one $60-million note that appears not to exist, having been repurchased by its issuer, the Student Loan Marketing Assn., in December, 1993.
“We repurchased it and retired it,” said Robert Levine, Student Loan’s vice president and treasurer, on Friday. He said the agency issued another $60-million bond at the time but did not know who bought it.
In fact, Citron bought it; both issues appear on the November inventory although only one is outstanding.
In a second case, the inventory appears to reflect the county’s ownership of $325 million of a Federal National Mortgage Assn. note issued July 13, 1992. Public records, however, show that only $200 million of the notes are issued and outstanding.
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Citron, who resigned Sunday, and county officials were unavailable Friday to comment on the discrepancies.
Many of the securities held in the county fund are so arcane that they cannot be priced for sale in today’s government securities markets, meaning that liquidating the county fund to raise desperately needed cash could be particularly difficult.
“A lot of these things are what we would call ‘toxic,’ ” said one government bond trader who examined the portfolio at The Times’ request.
Other traders note that the county faces special dangers in trying to sell such thinly traded securities in what all of Wall Street understands is a fire sale.
“The three ‘Ds’ are when you really make money as a buyer,” said one government bond trader. “Distress, death and divorce. When anyone sees distress coming, the prices really tank.”
The Times’ analysis further suggests that Citron may have piled borrowings on borrowings, evidently by pledging securities he had bought with borrowed money as collateral for further borrowing, in a process akin to mortgaging a house to 200% or 300% of its value. That would explain how the Orange County fund’s approximately $7.8 billion in equity supported borrowings of as much as $12.9 billion at the end of November.
For all that, financial analysts say the core of the county fund’s problems is its exceptional degree of leverage, which magnified Citron’s investment gains for at least three years, through the end of 1993, but exposed him to equivalently horrific losses once his basic investment strategy turned against him.
In fact, public documents indicate that the investment fund became increasingly addicted to borrowing as the bull market in interest rates came to an end. Orange County’s audited financial statement for the year ended June 30, 1992, for example, shows that the fund then had $4.7 billion in equity and about $3.9 billion in borrowings. That year it earned an investment return of 8.82%--beating the California state treasurer’s investment fund return by 2.6 percentage points.
A year later, as interest rates continued to fall, the scale of borrowing had outstripped the equity placed in the fund by the county and its more than 180 other investing municipalities, with $6.6 billion in equity supporting borrowings of $7.4 billion.
The fund’s return that year dipped to 8.52% but, turbocharged by Citron’s strategy of borrowing cheap short-term money to buy higher-yielding longer-term bonds, outdistanced the state treasurer’s return by 3.21 points.
But some financial analysts around the state were already beginning to sound warnings, if mild ones.
“When prevailing rates were 7% to 8% and everyone else was earning 4%, Orange County was at 9%,” recalls Steve Juarez, executive director of the California Debt Advisory Commission, a Sacramento body that counsels municipalities on selling bonds. “We consistently told people we dealt with that there’s no free lunch. Everyone understood there was added risk (in Citron’s portfolio) but no one, even up here, called him on it.”
Around that time Citron and investment bankers close to him began to promote a new and, as it was to turn out, treacherous idea: borrowing more to invest more. The county’s own level of borrowing for general purposes began to quicken, and Citron even persuaded four school agencies to float borrowings to add to his fund. Up to then Citron’s record and reputation were so sterling that the idea of borrowing tens of millions of dollars to let him play the financial markets seemed like sound judgment.
“We have the opportunity to make a million dollars on this,” Thomas Godley, then the assistant superintendent of Newport-Mesa Unified School District, said in an interview in 1993. “Wouldn’t it be fiscally irresponsible if we didn’t take that opportunity?”
The district floated a $47-million note issue in 1993 to reinvest with the fund--money that is now at best frozen, and at worst, lost.
For the investment environment was about to change sharply. The Federal Reserve board in February, 1994, boosted short-term rates by one-quarter point to 3.25%, shocking the financial markets and setting rates on their upward climb.
But Citron simultaneously stepped up his borrowing and leveraging. As the Fed began tightening, the Orange County fund’s equity was about $6.6 billion and its borrowings were $12.8 billion, for a leverage ratio of 2 to 1. By April the borrowing had reached $16 billion against an equity balance of about $7 billion.
Those increasingly expensive borrowed funds were going to buy increasingly exotic securities. Take one $100-million issue Citron purchased from the Federal Home Loan Bank via brokerage giant Merrill Lynch on April 15. The five-year note pays 5% until next May, at which point it converts to a payment formula of 5.6% plus five times the U.S. dollar two-year swap spread minus 0.28%.
The swap spread is a common benchmark in the money market, but bond analysts say the entire formula is so bizarre that it will be next to impossible to calculate a value for the notes if they come back on the market.
“You’d need several computers and a quantitatively oriented person to price this thing,” said one bond trader familiar with the security, who added that he wouldn’t try. “It’s an interesting piece of paper, to say the least.”
Many of these securities were specifically designed for sale into the Orange County portfolio by Merrill Lynch or other investment banks; Citron as often as not purchased entire issues, hundreds of millions of dollars at a swipe.
Some were so complex they were incomprehensible even to their issuers, the treasurers of government-sponsored financial agencies such as the Federal National Mortgage Assn. and the Student Loan Marketing Assn., known as Sallie Mae.
“This is something I couldn’t dream up myself to save my life,” said Sallie Mae’s Levine of the three-year note sold to Orange County and later repurchased.
Continuing to bet on falling rates, Citron kept stocking his portfolio with securities known as “inverse floaters,” so-called because as interest rates rise they actually pay the owner less and less interest. Consequently, the securities represent a bet that rates will fall.
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Some encompassed even more leverage in very subtle ways. One issue Citron bought as recently as Nov. 1 pays interest at 15.5% less two times the London Interbank Bank Offering Rate (LIBOR), a common money market benchmark.
However, the doubling factor effectively increased Citron’s exposure to adverse moves in rates, because every time LIBOR moved up a half-point Orange County received a full percentage point less in interest. Between January, 1993, when it first began paying interest, and last month, the interest paid on the note dropped from 8.25% to 2.5%. In other words, LIBOR gained 2 7/8 percentage points but the county lost 5 3/4 percentage points in annual interest.
Because of such formulas some notes held by Orange County have the potential to start paying zero interest just as money market rates are peaking at close to 6%, bond traders observe.
Some investment professionals argue that Citron’s practice of buying entire securities issues may have benefited the issuers and their investment banks far more than the county. Issuers love to have willing buyers with big appetites; it saves them the effort and expense of hawking their borrowings. They design the issues to meet the buyers’ demands, but that process may make them especially vulnerable to wrong guesses about the overall economic environment.
“My question to Merrill Lynch would be whether they ever did a ‘what-would’ analysis on a spreadsheet for the county,” said one bond trader familiar with the Citron portfolio. “What would happen if his guess was wrong?”
