ERisk.

com

sense,

the

bearing securities would maintain

eventual loss.)
Few municipal investors in the
pool quizzed Citron on how he

considerably

offset

or increase their value. He used var-

worked his magic, or analysed

billion of investments so that both

February 1994: Fed makes the first

independently the level of risk he

the returns and the risks were multi-

was running to gain excess returns.

that Orange County was itself

plied.
One way he did this was to enter
into contracts known as reverse

heavily invested in the pool.

repurchase

of a series of interest rate hikes,

and so threatens the directional
bet on interest rates built into the
Orange County investment pool.
September 1994: Orange County

However, the board of supervisors that acted as the principal

allowed him to use securities the

oversight for Citron's actions as

collateral on further borrowings,

Orange County treasurer lacked

and further cycles of investing. But

financial sophistication. Orange

these agreements left him vulnera-

County also failed to surround

ble to calls for more collateral if the

Citron with a compensating infra-

market value of the original collat-

structure of strict investment poli-

eral fell.

They took comfort from the fact

ious techniques to leverage his $7.5

billion of funds into more than $20

agreements,

which

pool had already purchased as

cies, risk controls, regular and

detailed reporting, and independent oversight. This mattered more
and more as the aim of the pool
gradually turned towards making,
rather than managing, money.
Through the early 1990s, Citron
enjoyed his growing importance as
someone who conjured up extra
money for public services. The
amount of public money in the
pool grew quickly until in 1994,
Citron was investing $7.5 billion in US
agency notes of various kinds. He

Citron used various

techniques to leverage his
$7.5 billion of funds into
more than $20 billion of
investments so that both
the returns and the risks
were multiplied

men from Wall Street's big broker-

Citron also used around $2.8 billion of structured notes, or deriva-

age firms, particularly those from

tives, to increase his bet on the

securities giant Merrill Lynch. Later,

structure of the interest rate yield

these salesmen would say they

curve.

were merely servicing an experi-

inverse floaters notes whose

enced and savvy investor, while

coupon falls as interest rates rise

Citron would claim he had been

as well as index amortising notes

misled about the riskiness of the

and collateralised mortgage obli-

instruments.
One thing is certain: while the
pool offered greater returns than

gations.
The relative complexity of the
instruments, the daisy-chain struc-

those of similar cash management

ture of the portfolio and Citron's lim-

pools, it did so only by taking on

ited financial reporting made it dif-

more risk. In particular, Citron gam-

ficult for independent critics to

bled that medium-term interest-

understand or prove how risky the

was a popular port of call for sales-

Timeline of
events

These

included

many

treasurer Robert Citron tries to calm

growing fears among investors.
November 1994: Auditors find that
the pool has massively lost value.
December 1, 1994: Citron confirms
that the pool faces $1.5 billion loss.
December 3, 1994: Citron resigns.
December 6, 1994: Prompted by
due date of certain repo
transactions, Orange Country files
for Chapter 9 protection.
May 2, 1995: US Bankruptcy Court
endorses settlement of what is left
in the investment pool. Some 241
participants get 77 cents in each
dollar of their investment balance
as a cash distribution.
November 19, 1996: Citron is
sentenced to a year in jail and
$100,000 fine.
December 17, 1997: Moody's
Investors Service rewards the
county's recovery and new
investment policies with an
investment grade rating for key
county borrowings.
June 2, 1998: Orange County
reaches a $400 million settlement
of its lawsuit against Merrill Lynch.
February 25, 2000: Some 200
municipal and governmental
agencies finally made good in a
disbursement of $864 million. But
Orange County continues to pay
off the recovery bonds it issued in
1995/6 to fund the bulk of the
pools losses.

June 2001

02

ERisk.com

strategy really was. But the end

That agreement proved elusive,

attracted risk-averse funds in the

result is clear: the pool transformed

and Wall Street institutions began to

sell off the securities they held as
collateral against their agreements
with Orange County. The Orange
County Board of Supervisors took
legal advice and declared bankruptcy on December 6, a move
that prevented investors withdrawing any more of their funds. It also
set the scene for a public auction
of Citrons investment portfolio so
that the proceeds could be reinvested in safe, and liquid, shortdated government stock.

first place.) But it is wrong to blame

By January 19, with this restructuring completed, Orange Countys

rides risk oversight.

short-term funds intended for vital

public services into a risky and
leveraged investment in mediumterm financial instruments.
As long as short-term interest
rates remained low, as they did in
the early 1990s, Citrons bet on the
relative value of medium-term
interest rate-linked securities paid
off and all concerned prospered.
The strategy soured with a shift in
policy by the Federal Reserve in
February 1994. That month saw the
first of a succession of hikes in interest rates that ultimately saw the Fed

one individual. The risk managers of

Canadian investment bank CIBC
recently compared the Orange
County failure to that of Barings
Bank, pointing out that in these otherwise very different debacles, the
man in charge showed excellent
results at first, and was therefore
allowed to transact without proper
surveillance or controls (Crouhy et
al, 2001). Orange County is primarily a story of what happens when
the desire for excess returns over-

The aftermath

Citron exposed a set of conservative investors with

specific funding needs to a risky portfolio. He failed to
communicate the extent of the market risk, or liquidity
risk, to either the investors or to his supervisory board
though he did not hide the fundamentals of his strategy

raise rates by some 2.25 per cent

over the course of 1994. By November, the investment pool was in
crisis as the value of its interest ratesensitive medium-term investments
sank, and calls for more collateral
arrived from Wall Street.
Citrons counterparties prepared

financial firestorm was over but its

losses had crystallised at around
$1.69 billion. Some expert commentators have argued that it could
have cut this bill if only it had had
the nerve to hang onto some of
Citrons investment portfolio.
But this makes little difference to

to seize and liquidate billions of dollars of the investment pools collateral, while the government entities
that had invested in the fund, lacking credible reassurances, looked
to withdraw their money. On
December 1, Citron admitted the
fund had lost around $1.5 billion or
around 20 per cent of its value. He
resigned on December 3, as
Orange County officials desperately tried to work out an agreement with their Wall Street creditors.

the fundamental lessons to be

learned from the debacle. Citron
exposed a set of conservative
investors with specific funding
needs to a risky portfolio. He failed
to communicate the extent of the
market risk, or liquidity risk, to either
the investors or to his supervisory
board though he did not try to
hide the fundamentals of his strategy. (Had he properly assessed
and communicated the level of
risk, the pool would not have

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 comJune 2001

03

ERisk.com

mitment to long-range financial

of the settlement that it had acted

finally made good. In February

planning and a stricter written pol-

properly and professionally in our

2000, officers appointed by the

icy for investments. In December

relationship with Orange County. It

courts paid out around $864 million

1997, Moodys Investors Service

cited the costs, distraction and

to various government entities that

rewarded the county with an

uncertainty of further litigation as

had suffered from the collapse. Five

investment grade rating for key

the reason it had come to make

years on from the bankruptcy, it

borrowings.
The new Orange County investment policy statement establishes

such an expensive settlement,

was a big day for the smaller credi-

while assuring its investors that it

tors. But on the same day, Orange

had already fully reserved against

County

safety of principal, and liquidity, as

such an outcome.

reminded local reporters that the

the primary objectives of the fund,

Together with settlements from

more than 30 other securities

county itself was still paying off

with yield as a secondary objective. More specifically it prohibits

houses, law firms and accountancy

bonds issued in 1995 and 1996

borrowing for investment purposes

firms that the county held partly

and would be for several decades,

(ie, leverage), reverse repurchase

responsible for the losses, the

agreements, most kinds of struc-

money from Merrill Lynch meant

unless it was able to speed up

repayments. !

tured

that some 200 municipal and gov-

notes

(such

as

inverse

floaters) and derivatives such as

ernmental

agencies

could

be

supervisor

Jim

Silva

some $1.2 billion of the recovery

Rob Jameson is reference editor

at ERisk

options. The same document bans

the treasury oversight committee

Resources and References

and other designated employees

from receiving gifts, and obliges
them to disclose economic interests
and conflicts of interest. The county
treasurer

now

has

to

Mark Baldassare, When Government Fails: The Orange County

Bankruptcy, Public Policy Institute of California and the University of
California Press, 1998. Overview available here.

submit

monthly reports to the investors and

other key county officers that contain sufficient information to permit
an informed outside reader to eval-

Steven Cohen and William Eimicke, Is Public Entrepreneurship Ethical?:

A Second Look at Theory and Practice, see section on The Financial
Collapse of Orange County, which discusses the high regard in which
Robert Citron was held before his fall from grace.

uate the performance of the investment programme.

On June 2, 1998, Orange County
reached a massive $400 million set-

Michel Crouhy, Dan Galai and Robert Mark, Risk Management,

McGraw-Hill, 2001, page 34, available through www.amazon.com

tlement with Merrill Lynch, the firm it

Richard Irving, County in Crisis, Risk, March 1995, pp 2733.

held most responsible for steering

Citron towards what the county
deemed risky and unsuitable securities. Thomas Hayes, who led the
countys

litigation,

said

Philippe Jorion and Robert Roper, Big Bets Gone Bad: Derivatives and
Bankruptcy in Orange County, Academic Press (1995), available
through www.amazon.com

he

regarded the settlement as fair

Philippe Jorions Internet case study: Orange County Case Using

while Janice Mittermeier, Orange

Value-at-Risk to Control Financial Risk

County CEO in its recovery period,

said the resolution assures county
taxpayers that those responsible for

Orange County press release, Bankruptcy Court Will Hear County's

Case Against Investment Broker Merrill Lynch, December 1, 1995

the losses that caused the countys

bankruptcy

are

being

held

accountable.
Merrill Lynch maintained as part

Russ Banham, Local Hero, Treasury and Risk Management

Magazine, October 1998

June 2001

04