MARGIN CALL : Orange County’s Romance With High Yields Has a High Price
If you borrow money from your Uncle Eddie to bet at the race track, it’s fun as long as you keep on winning, but very unpleasant if you lose--particularly if he kept your car as collateral.
That’s basically what Robert L. Citron, the just-resigned Orange County treasurer did with the money in the county investment pool. He borrowed about $12 billion to buy government bonds and notes that he thought would rise in value. But he guessed wrong, and his lenders, like your Uncle Eddie, have sold off the collateral. The eventual cash losses to the participating local governments could far exceed earlier estimates of $1.5 billion.
Almost as shocking is the failure of oversight, from the state Treasurer’s office right down to the Orange County Board of Supervisors. Citron made no secret of what he was doing, and any competent professional would have understood how exposed he was. But because his returns were so good for so long, everyone pretended that merry-go-rounds never stop. The behavior of Merrill Lynch, Citron’s primary investment adviser over the past year or so, is even more disgraceful. By all accounts, Merrill rang up huge investment fees by feeding Citron’s recklessness like a bartender pushing drinks on a drunk driver.
The root cause of the fiasco is that California, as is now so painfully obvious, has no effective standards for monitoring how local governments invest. With so much taxpayer money at stake, such neglect is indefensible.
Some years ago, California kept control by imposing rigid legislative limits on local investment alternatives. Citron himself pushed through reforms that lightened up the old rules. He was not wrong to do so. Intelligent use of derivatives, for example, will allow a conservative manager to insulate his portfolio from sudden ups and downs in the market. But it appears, despite warnings, that no one ever looked over Citron’s shoulder to see what he was doing--not the state Treasurer, not the bond-rating agencies, not the county supervisors. If they had, they would have seen that he was behaving recklessly, to the point where a massive comeuppance was virtually inevitable.
The local jurisdictions investing in the Orange County pool--some were legally mandated to keep their funds in the pool--are not the sort of high-rollers who can afford unpleasant surprises. This is taxpayer money targeted for specific public purposes, like pensions and capital construction. Preservation of principal by low-risk investing at market returns should be the core strategy. Allocating a small portion of the pool for so-called “enhanced” return investing would have been reasonable--but never the kind of wholesale gambling Citron indulged in.
At first glance, Citron’s portfolio looks conservative since it consists almost entirely of high-quality government bonds and notes--but few amateur investors realize how risky such instruments can be. If the government makes a promise to pay you interest of, say, $5 a year, forever, there is no question it will keep that promise. The risk comes when you need cash and try to sell that promise on the open market. If interest rates are 5%, the promise to pay $5 a year forever will be worth about $100. If interest rates are 10%, the same promise will be worth only about $50. The resale value of the bond, that is, changes quite dramatically when interest rates move up and down. The government’s 30-year bond changes in value about 10% for every 1% change in interest rates. The 10-year note moves about 7% for every 1% change in rates. Since 10-year rates have gone up about 2% this year, the market value of a 10-year note has gone down about 14%. If you bought $1,000 worth of 10-year notes a year ago, you could sell them today for only about $860.
Although Citron’s problems are being blamed on investments in mysterious “derivatives,” it is far simpler than that. He borrowed money to buy bonds, betting interest rates would fall and the value of the bonds would go up. He could then sell the bonds, pay off his loans and pocket a big profit for the pool. (He didn’t actually have to sell anything; instead, he would just book a daily paper profit, and renew the loans.) Since interest rates fell year after year for more than 10 years, it was a strategy that paid big dividends for a long time. Citron looked like a genius, and the pool investors began to count on his hefty returns to infuse cash into local budgets.
Citron’s luck turned when the long downward trend in interest rates bottomed out in late 1993, then began to turn sharply up earlier this year. Instead of helping Citron unwind his positions and minimize his losses, Merrill stuffed the Orange County portfolio with some $4 billion in government mortgage-pool investments--far more volatile instruments than conventional bonds and notes.
As Citron’s cash reserves began to run out, Merrill even underwrote a billion-dollar Orange County note issue, allegedly without telling investors it was designed to shore up Citron’s collapsing position with his lenders. If investors were not fully informed of the purpose of the note sale, and the state of Citron’s pool (on first blush, it is not likely that they were--even by Wall Street’s elastic standards), both Orange County and Merrill could be guilty of fraud. The Securities and Exchange Commission has already begun an investigation.
Earlier last week, Orange County officials stressed that Citron’s losses were just “paper” losses--since the government will eventually pay off all its bonds and notes. But that’s not the way the world works. When banks lend money to buy bonds, they keep the bonds as collateral. As the value of Citron’s bond portfolio dropped, he had to keep coughing up additional collateral in the form of cash. As a consequence, the bank loans were always fully secured--while the pool’s cash reserves ran down from more than $2 billion to almost nothing in just a few months.
When the banks finally decided that Citron could no longer come up with cash to meet their collateral calls, they refused to renew their loans, plunging the pool into default and precipitating the current crisis. Ironically, Merrill, who was obviously getting paid coming and going, was one of the banks that cut off the loans and forced the default. Most people might find that slimy, but it apparently fits Wall Street’s notion of ethics.
Since the bank loans were fully collateralized, the banks are not at risk. They will keep the cash and sell the bonds for whatever they can get. CS First Boston has reportedly already gotten out of a large position relatively cleanly. As the banks unwind their collateral positions, Orange County’s losses, now estimated at somewhere between $1.5 and $2 billion, will be “realized”--that is, will become actual cash losses. The bankruptcy proceedings will slow that process down, but there’s no question how it will end.
Bankruptcy is a scary word--but in all likelihood, it will not have a disastrous impact on the county. Local government operations will continue unimpeded, although there may be temporary cash squeezes that could cause some districts to delay payments on their bonds. The main reason for the bankruptcy declaration is to head off a run on the investment pool, so Citron’s positions can be unwound in a more or less orderly fashion, which is just common sense.
But the fact remains that Citron and his allies on Wall Street managed to spirit away at least $2 billion of local government money. That is not chump change. The county, and its constituent local governments, are rich enough to absorb the blow--but over the next few years, local taxpayers will have to stump up that much extra cash, or endure reduced levels of government services until their nest eggs are back in order.
There are scattered reports from around the country that many other local governments may have been lulled, or lured, or wittingly walked into, the same kind of dangerous investment strategies. One hopes that state Treasurers or controllers are hopping on their motorcycles. There is no need to legislate permissible investments or to outlaw “derivatives,” but merely to exercise common sense. The huge risks in Citron’s strategy were so apparent to professionals that they were even a campaign issue in his last election. Waiting for accidents to happen will only ensure they are far worse than they ought to be.*
