Another source with more detail... if curious
Introduction:
On December 6 1994, Orange County, a prosperous district in California, declared bankruptcy 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 conservative but profitable way of managing the countys cashflows, and those of 241 associated local government entities. Instead, it triggered the largest financial failure of a local government in US history.
Robert Citron, the hitherto widely respected Orange County treasurer who controlled the $7.5 billion pool, had riskily invested the pools 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 billions of dollars of collateral from Citrons 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 undertaken such a risky investment strategy 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 governance, and established a stricter set of investment policies.
Lessons Learnt:
- Beware the unconstrained star performer, even when he or she has a long track record. Where theres excess reward, theres risk though it might take time to surface;
- If the organisational structure, planning and risk oversight mechanisms of an institution are fractured, it is easy for powerful individuals to hide risk in the gaps;
- Borrowing short and investing long means liquidity risk, as every bank knows;
- Risk-averse investors must tie investment objectives to investment actions by means of a strict framework of investment policies, guidelines, risk reporting and independent and expert oversight;
- Risk reporting should be complete, and easily comprehensible to independent professionals. Strategies that are not possible to explain to third parties should not be employed by the risk averse.
(I eliminated the details, as it is not relevant to this discussion... it regards misinvesting funds, which isn't the case here.)
The Aftermath: Restitution and Recovery
Citron eventually pleaded guilty to six felony counts. However, the charges were largely to do with a misallocation of returns between the county and other municipal entities, and Citron does not seem to have been motivated by personal gain of any direct and obvious kind. He paid a $100,000 fine and spent less than a year under house arrest.
If that seems a lenient sentence, then Orange Countys recovery was also swifter than might have been expected. It had to cut back on spending and social service provision, and in 1995 and 1996 it took on massive additional debt in the form of special long-term recovery bonds to cover its losses. But thanks to increased tax revenues from a buoyant local economy, it was able to exit from bankruptcy in only 18 months.
With new executives in charge, it instituted a series of governance structures and reforms. These included oversight committees, an internal auditor who reported directly to the supervisors, a commitment to long-range financial planning and a stricter written policy for investments. In December 1997, Moodys Investors Service rewarded the county with an investment grade rating for key borrowings.
The new Orange County investment policy statement establishes safety of principal, and liquidity, as the primary objectives of the fund, with yield as a secondary objective. More specifically it prohibits borrowing for investment purposes (ie, leverage), reverse repurchase agreements, most kinds of structured notes (such as inverse floaters) and derivatives such as options. The same document bans the treasury oversight committee and other designated employees from receiving gifts, and obliges them to disclose economic interests and conflicts of interest. The county treasurer now has to submit monthly reports to the investors and other key county officers that contain sufficient information to permit an informed outside reader to evaluate the performance of the investment programme.
On June 2, 1998, Orange County reached a massive $400 million settlement with Merrill Lynch, the firm it held most responsible for steering Citron towards what the county deemed risky and unsuitable securities. Thomas Hayes, who led the countys litigation, said he regarded the settlement as fair while Janice Mittermeier, Orange County CEO in its recovery period, said the resolution assures county taxpayers that those responsible for the losses that caused the countys bankruptcy are being held accountable.
Merrill Lynch maintained as part of the settlement that it had acted properly and professionally in our relationship with Orange County. It cited the costs, distraction and uncertainty of further litigation as the reason it had come to make such an expensive settlement, while assuring its investors that it had already fully reserved against such an outcome.
Together with settlements from more than 30 other securities houses, law firms and accountancy firms that the county held partly responsible for the losses, the money from Merrill Lynch meant that some 200 municipal and governmental agencies could be finally made good. In February 2000, officers appointed by the courts paid out around $864 million to various government entities that had suffered from the collapse. Five years on from the bankruptcy, it was a big day for the smaller creditors. But on the same day, Orange County supervisor Jim Silva reminded local reporters that the county itself was still paying off some $1.2 billion of the recovery bonds issued in 1995 and 1996 and would be for several decades, unless it was able to speed up repayments.
SOURCE: http://www.erisk.com/Learning/CaseSt...angecounty.asp