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Unformatted text preview: O n December 6 1994, Orange County, a pros- perous district in Cali- fornia, declared bank- ruptcy after suffering losses of around $1.6 billion from a wrong- way bet on interest rates in one of its principal investment pools. The pool was intended to be a conser- vative but profitable way of man- aging the county's cashflows, and those of 241 associated local gov- ernment entities. Instead, it trig- gered the largest financial failure of a local government in US history. Robert Citron, the hitherto widely respected Orange County treas- urer who controlled the $7.5 billion pool, had riskily invested the pool's funds in a leveraged portfolio of mainly interest-linked securities. His strategy depended on short-term interest rates remaining relatively low when compared with medium- term interest rates. But from February 1994, the Federal Reserve Bank began to raise US interest rates, causing many securities in Orange Countys investment pool to fall in value. During much of 1994, Citron ignored the shift in the interest rate environment and the mounting paper losses in his portfolio. But by the end of 1994, demands for bil- lions of dollars of collateral from Citron's Wall Street counterparties, and the threat of a run on deposits from spooked local government investors, created a liquidity trap that he could not escape. Citron could not have under- taken such a risky investment strat- egy if his actions had been subject to informed and independent risk oversight and detailed risk-averse investment guidelines. Following the debacle, Orange County revised many aspects of its control procedures and its financial gover- nance, and established a stricter set of investment policies. The story Orange County treasurer Robert Citron was no new kid on the block. He had been treasurer since 1972 and in early 1994, at about the time his investment strategy began to go sour, he survived an election that focused public attention on his financial management of the Orange County investment pool. Citron managed to convince vot- ers that the criticisms, which turned out to be close to the mark, were politically motivated. Citron's strongest card was his track record. Earnings from the investment pool had been an increasingly important part of the Orange County budget since the late 1970s, leading to a relaxation of the rules surrounding how funds could be invested. In addition to the county itself, municipal entities such as the Orange County cities of Anaheim and Irvine, along with var- ious local government authorities and services, were attracted to the investment pool by the unusually good rates of return it offered. These investors put money that they raised from taxes and other sources into the pool, in the hope that the cash would grow before they had to spend it on vital public services. Excess returns from the pool were particularly welcome in the early 1990s: the local political environment was set against raising taxes and local government finances were under increasing...
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- Fall '08