Academic journal article The Government Accountants Journal

Government Investing: Despite Reforms, Are Public Funds Still at Risk?

Academic journal article The Government Accountants Journal

Government Investing: Despite Reforms, Are Public Funds Still at Risk?

Article excerpt

IN DECEMBER 1994, ORANGE COUNTY, CALIFORNIA, SHOOK THE INVESTMENT WORLD BY FILING FOR BANKRUPTCY. THE RISK-TAKING THAT LED TO ORANGE COUNTY'S BANKRUPTCY AND THE LOSSES ALSO EXPERIENCED IN TEXAS, OHIO AND FLORIDA ARE NOT NEW. IN FACT, SIMILAR FINANCIAL DEBACLES, ALBEIT NOT OF ORANGE COUNTY'S MAGNITUDE, OCCURRED IN GOVERNMENT AND INDUSTRY LONG BEFORE THE EVENTS OF 1994. WHILE GOVERNMENT AND FINANCIAL LEADERS HAVE RESPONDED WITH PUBLIC INVESTMENT REFORMS AND INCREASED DISCLOSURE REQUIREMENTS, WE BELIEVE THEY HAVE NOT GONE FAR ENOUGH TO PROTECT THE PUBLIC'S BEST INTEREST AND THAT FUNDS MAY AGAIN BE PUT AT RISK. AS THE SHOCK OF ORANGE COUNTY FADES INTO THE PAST, WE MUST ENSURE THAT HISTORY DOES NOT REPEAT ITSELF.

TO FULLY UNDERSTAND THE PITFALLS FACING PUBLIC INVESTING, WE MUST FIRST EXAMINE THE MISTAKES OF THE PAST. WE WILL THEN ADDRESS THE LATEST PROPOSALS TO LIMIT UNACCEPTABLE INVESTMENT PRACTICES AND THE RECENT NATIONAL EXPANSION IN DISCLOSURE AND REPORTING REQUIREMENTS. FINALLY, WE WILL EXPLORE THE IMPACT SUCH CHANGES WILL HAVE ON FUTURE INVESTMENT PRACTICES AND PROPOSE ADDITIONAL MEASURES THAT MUST BE CONSIDERED.

THE ORANGE COUNTY EXPERIENCE

On a dark Tuesday in December 1994, Orange County officials realized that the county could not meet collateral demands, so they filed for bankruptcy. Before that day, Orange County had enjoyed economy-defying prosperity. It seems as though the county's rich tax base protected it from the deep budgetary cuts incurred by other California counties. In fact, nearly 35 percent of the county's $463 million budget was premised on investment earnings comprising its largest revenue source--almost 37 percent higher than property tax revenues.1

However, Orange County's former treasurer, Robert L. Citron, took huge risks investing the pooled operating funds under his control. While cautious investors steered clear of practices that seemed too good to be true, others believed Orange County was setting the pace for government investment pools. Over the years, the number of entities voluntarily and involuntarily participating in the Orange County investment pool grew. By December 1994, the pool included nearly 190 public agencies with contributions totaling $7.6 billion. In the end, the deal was too good to be true, and participants faced a $1.69 billion collective loss--more than 22 percent of the base portfolio.2

What the State Auditor discovered while auditing the aftermath of Orange County's bankruptcy was that Robert Citron pursued an investment strategy that violated the basic tenets of prudent investment practices: it was highly risky, it was extremely volatile and it lacked liquidity. His strategy involved leveraging or borrowing billions of dollars to obtain cash for investments. These borrowed billions were then used to purchase securities, known as derivatives, that were highly sensitive to changes in interest rates.3 When the Federal Reserve increased short-term interest rates several times during 1994, the value of many of the derivatives fell precipitously.

What Caused Orange County's Losses?

No single factor caused the county's losses. The losses were the result of a dangerous amalgam of several high-risk strategies the treasurer used to increase his investment yield. First, the portfolio was highly leveraged through the use of reverse repurchase agreements. Specifically, shortly before the bankruptcy, Citron had leveraged the investment pool more than 2.7 times. Second, a large proportion of the proceeds from this borrowing was invested in derivatives whose value declined as interest rates rose. Third, Citron invested funds from short-term borrowing to purchase long-term securities and thus, cash was unavailable to repay loans as they became due. During 1994, the sum of these three scenarios reached the combustion point when short-term interest rates sharply increased, directly opposite of the treasurer's market "bets."

Reverse Repurchase Agreements

Using reverse repos, Citron was able to dramatically increase the portfolio's size; by November 30, 1994, he had leveraged the base portfolio of $7. …

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