O.C.’s Prospects for Recovering Damages
In its attempts to recover the $1.6-billion hole left by the bankruptcy, Orange County is now facing its most important milestone. In January, District Court Judge Gary Taylor is due to rule on the legality of the “reverse repurchase agreements,” transactions between the Orange County investment pool and its brokers. The amounts at stake are considerable: Most notably, the county is suing Merrill Lynch for $2 billion.
To understand these transactions, also called reverse repos, consider the following example: Former Treasurer-Tax Collector Robert L. Citron was entrusted with about $7 billion of investors’ money, which was initially invested in, say, a $7-billion Treasury 5-year note. He then sold this note against $7 billion in cash and a promise to buy it back later at a fixed price. Due to this “repurchase” agreement, he was still exposed to fluctuations in interest rates. Citron then recycled the cash into another $7-billion note, thus doubling the bet. Matthew Raabe, the former assistant treasurer, described this operation as a “slam dunk,” so why stop there? This operation was repeated a second time, leading to a total portfolio of $21 billion. Quite a big bet.
The question before the court is whether these transactions were legal. The county contends that these repos were “collateralized loans,” which increased the debt level of the county beyond its statutory limit of annual revenues. Merrill, in contrast, argues that these transactions should be viewed as “sale-repurchases” of securities, in which case they are perfectly legal.
Previous legal decisions offer mixed guidance. In tax treatment cases, repos are viewed as collateralized loans. In securities fraud and bankruptcy cases, repos are considered sale-repurchase agreements. For the county, this seemingly arcane distinction is a billion-dollar question. If the transactions are found illegal, the county is bound to collect huge damages from brokerage houses. If not, prospects for full recovery are dim.
The problem is that this issue affects not only Orange County, but a global market of $1.5 trillion in repos. Mutual funds, for instance, routinely use repos for secured investment of their cash. The repo market is based on the premise that these transactions are sale-repurchases, not loans. A finding that reverse repos are illegal would throw the market in turmoil and, for instance, require all California municipalities that entered these contracts to declare them void. The ironic aspect of this court battle is that, before 1994, the county argued that these transactions were perfectly valid.
In the battle of billions that will unfold next year, there will be only losers. Even if the county wins, it is unlikely to recover the full amount it has lost. The sole positive aspect of this story is that debacles such as Orange County, Barings, Daiwa, and the like have spurred the financial industry toward better risk-management practices.
