October 1


For those who have been added to the Moorlach Update in recent months the article below may be a good tutorial on what our county went through sixteen years ago.  Fifteen years ago I was appointed to the position of Treasurer-Tax Collector.  It was a busy, busy year.  I do not have many of the articles organized for inclusion in the Updates.  If I did, it may be information overload.  Consequently, on an occasional basis you’ll get a piece like the one published in the Ohio Securities Bulletin, a quarterly publication of the Ohio Division of Securities.  The title of the lead article was “Frankenstein Roams God’s County:  Orange County Fiasco Demonstrates the Perils the Use of Derivatives Can Pose to Public Funds” and it was written by Desiree T. Shannon, Esq.  I’m providing it in full, with footnotes, as it provides a professional and unbiased perspective of the events that the OC is now famous for.

The word derivatives, used in the context of the securities industry, has taken on the sort of patina that used to be reserved for a word on the order of hemorrhoids. Some commentators have indeed likened certain derivatives to some dangerous and painful growth that is plaguing the backside of the securities industry, characterizing them as the equivalent of “toxic waste.” These attitudes are no doubt borne by numerous high-profile fiscal debacles in and outside of Ohio. In the late ’80s and early ’90s, public officials purchased these complex, highly volatile securities from various brokers; the derivatives, in turn, supplied outstanding yields, sometimes double those of conventional “vanilla” securities. But public officials discovered the dark side of these godsend securities when interest rates began to fluctuate in the early ’90s.

A derivative’s value, by definition, is derived from the performance of an underlying asset, such as a mortgage-backed security, a currency, or interest rate. Most derivatives purchased for public funds were based on mortgage-backed securities but also tied in some fashion to interest rates, their value being dependent upon the direction interest rates were moving (see “An Introduction to Mortgage-Backed Derivatives” below). Public investment funds sustained huge losses when interest rates began moving away from the direction favorable to the derivatives’ value. Many public funds quietly housed these securities for years, not realizing any danger until the damage was evident.  In most cases, the losses resulted from the misuse and mismarketing of derivatives (see “Division Revokes…” supra p. 8).

Perhaps a more fitting allegory to the derivative dilemma would be that of Frankenstein’s monster. Frankenstein’s monster, like these securities, was a complex hodgepodge creature, that, in essence, was not inherently bad. He turned bad, however, because people misunderstood and misused him.  This theme of misunderstanding and misuse of derivatives was played out in operatic proportions in no place other than Orange County, California, the sunny bastion of suburban bliss that begot the Magic Kingdom, Richard Nixon and Proposition 13.  For in December 1994, Orange County was brought to its knees (and managed to drag many others down with it) because its long-time treasurer, Robert L. Citron, had sunk the County’s investment pool with exploding derivatives, and, even worse, had done so through a complicated leveraging arrangement with several  large investment firms.

Voodoo Investment Strategy inthe Magic Kingdom

In retrospect, Robert L. Citron seemed an unlikely participant in the destruction of Orange County’s investment pool, which contained billions of dollars in funds. Citron, who had been Orange County’s treasurer since 1973, was said to be so conservative with his own finances that he kept most of his own money in bank accounts.1  In 1979, Citron was instrumental in getting the California legislature to change state law to allow counties to borrow money through arrangements called reverse repurchase agreements.2  Using these agreements, Citron borrowed funds from various investment banks against the pool’s $7.5 billion in investment holdings, leveraging the fund to more than $20 billion.3

Reverse repurchase agreements typically allow public fund managers to buy securities, while simultaneously pledging them to an investment bank as collateral for a loan.4  If an investor uses the loan to purchase a security of comparable value and yield, and he or she is being charged a low interest rate for the loan, the yield on the underlying security increases as long as interest rates remain stable.5  If interest rates go up, a double squeeze occurs, because he or she is using short-term borrowing (reverse repurchase agreements typically have a life of not more than 60 or 90  days) to purchase long term investments.  The value of the collateral drops, causing the lender to demand additional collateral to make up the difference.  Additionally, the agreements are rolled over, increasing the danger that the cost of the loan may rise above the return on the underlying investment in the wake of fast-rising interest rates.6

What made Orange County’s use of reverse repurchase agreements even more precarious was that a significant portion of Orange County’s collateral pool was made up of derivatives called inverse floaters, whose market values and interest rates decline by a multiple of any increase in the market rate.7

This risky investment strategy paid off temporarily for Orange County and its many pool participants, which included school districts, public safety departments and city governments who were attracted by the fund’s investment return of up to 9%.8  But the alarm bells began to sound in early 1994, when interest rates began to inch up.  In March 1994, John Moorlach, an accountant who was Citron’s Republican opponent in an upcoming election, had the fund’s financial statement evaluated by several bond brokers, who he claims were troubled by what they found. He

tried to use the fund’s problems as an election issue, attempting to stir up media interest. However, his attempts fell on the deaf ears of the media and the public, who were star-struck by the high-rolling Citron’s impressive returns on the fund. Citron was re-elected as the fund continued to reach a crisis point.9

Orange County’s financial time bomb exploded in early December 1994, when most of its lenders refused to roll over reverse repurchase agreements with the county, demanding cash and additional collateral.10  With the value of the fund diving, county officials had approached several Wall Street firms in an attempt to liquidate the fund’s plethora of troublesome derivatives.  All of the firms ran away screaming after reviewing the fund’s portfolio.11  Meanwhile, the investment bankers who had extended loans to the fund demanded payment, forcing Orange County into default on most of the loans. Most of the banks, in turn, liquidated the fund’s collateral.12  On December 6, 1994, Orange County became the largest municipality in U.S. history to file for bankruptcy protection. Needless to say, Citron resigned as Orange County treasurer.13

Fall-Out and Finger-Pointing

Predictably, once Orange County’s bankruptcy became public, investors holding municipal bonds issued by the county began screeching like a chorus of scorched cats. They commenced lawsuits against the county, as well as brokers who sold the bonds, such as Merrill Lynch and Smith Barney, claiming the firms concealed the county’s “reckless investment practices.”14  Orange County bondholders were not the only ones fearful of the situation; investors around the country were afraid other municipalities who had delved into similar investments would be forced to crawl

            out of the dark, like cockroaches on the march to bankruptcy court.15

The SEC launched several investigations relating to the crisis.  The SEC itself was stung by criticism from Orange County officials that it had refused to take steps that would have forestalled a bankruptcy because it wanted to pressure Congress into giving it more power to regulate the municipal securities market.16  An SEC enforcement official colorfully denied the allegation, saying that “…we’re not responsible for the financial condition of this county…(s)omebody must have been smoking something or dropped in from planet Mars.”17  Initially, the SEC was investigating Citron’s activities, particularly regarding risk disclosure issues to pool participants. Regulators were also reviewing the possibility that Citron shifted bonds among various accounts at book value, rather than market value, to shuffle gains and losses among various members of

the investment pool.18

The investigation eventually widened to include brokerage firms such as Merrill Lynch, who sold Orange County municipal securities during the summer of 1994, and whether proper disclosures were made regarding the fund’s losses, which were becoming apparent by that time.19  Regulators were also questioning possible campaign contributions by certain brokers to Orange County officials’ election campaigns.20  Arthur Levitt, Chairman of the SEC, chastised the Orange County Board of Supervisors for allowing Citron such free reign regarding investment practices, saying “(I)f your supervisors are so lax that they allow you…to make that kind of speculation, I think the voters of that community should throw the whole bunch out of office.”21

County officials and brokers were not the only ones at the end of a finger. Rating agencies, such as Standard & Poor’s and Moody’s Investors Service, were pummeled for giving high ratings to the county’s general obligations up to the day of the bankruptcy.22  The agencies countered that their ratings were merely based on information provided by Citron, claiming that he understated his fund’s derivative position.23  After Orange County’s problems, the agencies stepped up inquiries to public bond-issuing entities regarding possible use of derivatives.24

Of course, Citron remained at the center of the dark, mushrooming cloud hanging over Orange County. Early on, Citron attempted to portray himself as an innocent trapped in a jungle that was ruled by financial wolves. At a hearing conducted by a special committee appointed by the California Senate in January 1995, he claimed he was an “innocent investor” who relied on advice from “financial professionals,” primarily at Merrill Lynch.  He claimed he relied on a statement by an official at Merrill that the interest rate increases would not last into 1994.25  In response to Citron’s remark, Merrill claimed it did not determine the county’s investment strategy, and attempted to warn Citron that the county’s fund could sustain big losses as interest rates rose.26  Meanwhile, Citron also managed to deflect some blame to the Board of County Supervisors, whom

he said never asked for monthly reports as required by California law.27

In preparation for criminal charges being formulated against him, Citron began laying groundwork for a defense. His defense basically consisted of two points:  that the risky investments primarily responsible for sinking the county’s portfolio were permissible under California law, and that he made full disclosure of their risky nature to everyone whom he owed a duty to do so.28  He also maintained that pool investors should have realized how risky the county’s investment pool had become, given that their level of sophistication was comparable to his.29  However, investigators and regulators noted the contradiction in the fact that Citron claimed to have no knowledge of the financial issues that figured in the pool’s loss, yet advised pool investors of risk elements of the pool, often either minimizing or tempering these elements with overly-optimistic

market opinions.30  Still, a lot of respected financial players had held the same views, and legal experts debated whether information Citron passed onto investors was unreasonable.31

Ultimately, Citron was charged criminally and pled guilty in April to several fraud-related charges, although none of them alleged any of his activities served the purpose of personal gain.32  The felony charges dealt primarily with Citron’s efforts to cover losses the pool was sustaining by making false bookkeeping entries and manipulating accounts.33  Citron still awaits sentencing and is participating in investigations spurred by various governmental agencies at the state and federal levels.34  He now says he suffers from a progressive brain disease which made it possible for others to mislead him into making bad decisions regarding the fund.35

In the year since Orange County’s financial meltdown, the county still finds itself in financial tumult. Orange County voters soundly rejected a sales tax increase to ease the County’s financial woes.36  However, the county managed to pay back pool investors most of their principal, blunting cuts in local government services.37  The county continues legal maneuvering in attempts to deal with angry bondholders, some of whom have accused the county of trying to avoid its moral and legal obligations.  One SEC official mused at the bondholders’ dilemma, noting that in the

event of default, they “couldn’t seize the courthouse. All you have is the word of the…county behind these bonds.”38

Some TroublingQuestions Linger

In observing the Orange County fiasco, no one clear villain emerges.  The episode has certainly made investors wary of derivatives like those that were loaded into the Orange County investment pool, as well as financing strategies that allow the borrowing of huge sums of money to buy them.  It is true that, by definition, many types of derivatives are highly volatile instruments.  After all, their performance is based on underlying factors that are themselves volatile and unpredictable, such as interest rates. Very few people would have predicted just a few years ago that interest rates would drop into the single digits, much less rise again significantly in just one year.  Moreover, as Citron discovered, these types of securities can be highly profitable—as long as the investor is of a sort who has money to gamble away in the event of a sour turn. Regulators

have challenged whether securities such as these should ever be sold to a public entity, and have investigated how such securities are marketed.  An investor who purchases these securities not fully understanding how they work and assuming they guarantee any degree of safety is likely to find his or her financial house crushed by the investing world’s equivalent of Frankenstein’s monster.

If there is blame to go around regarding the county’s woes, it falls squarely on the shoulders of anyone and everyone involved (or notably uninvolved) in structuring the investment pool, as well as those who have tried to escape the consequences if its demise. This not only includes Citron,

but many other government officials in California. It also includes investment banks and brokerages who reaped huge fees from financing and selling derivatives to the fund.  And ultimately, some blame must be put on taxpayers of all economic classes who don’t want to pay increased

taxes, yet gladly consume an ever-escalating level of government services that go way beyond basics such as law enforcement, road maintenance and education.

Most politicians are understandably afraid of being honest with taxpayers by telling them that nothing can be gotten for free and that citizens must decide whether they want to pony up or pare down. Measures like Proposition 13 have made it much more difficult for governmental entities

to raise money. Fear of taxpayer reprisal makes it far easier for government officials to look toward complex, quick-money schemes of the type that battered Orange County’s financial health. It makes it easier for them to ignore early warning signs of impending financial catastrophe. It

makes it easier for them to look the other way when the returns on investments seem just a little too good to be true. It makes it easier for them to form perhaps what could be characterized as unhealthy symbiotic relationships with huge financing institutions.

For a long time, everyone involved in the Orange County fiasco was getting what they wanted at the financial table. Investment bankers and brokerages were getting fees; county officials were getting high praise for bringing in large amounts of revenue without having to raise taxes; and Orange County residents were getting a high level of services without having to pay extra for them in the short term. But everyone choked when they got the final bill.  


1. Greenwald, The California Wipeout; Orange County Files for Bankruptcy after Losing Big on High Risk Investments, Time, Dec. 19, 1994, at 55; L.A. Times, Dec. 3, 1994, at 1, col. 5.

2. Greenwald, supra.

3. American Municipalities; Citron Presse, The Economist, Dec. 10, 1994, at 7.

4. Id.

5. L.A. Times, Dec. 3, 1994, at 1, col. 5.

6. Id.

7. Coffee, The Suitability Doctrine Revisited: Can Orange County Sue Its Broker for Recommending the Purchase of Unsuitable Securities for Its Fund?, The National Law Journal, Jan. 16, 1995 at B4.

8. Greenwald, supra.

9. Davis, Investing, Kiplinger’s Personal Finance Magazine, April, 1995, at 75.

10. The Economist, supra.

11. L.A. Times, Dec. 7, 1994, at 1, col. 5.

12. Id.

13. Id.

14. New York Times, Dec. 10, 1994, at 39, col. 6.

15. Id.

16. L.A. Times, Dec. 8, 1994, at 1, col. 6.

17. Id.

18. Mathews and Machen, Securities Enforcement, Insights, June 1995, at 3.

19. L.A. Times, Dec. 10, 1994, at 1, col. 1.

20. New York Times, Dec. 16, 1994, at 39, col. 6.

21. Id.

22. Davis, supra.


23. Id.

24. Id.

25. New York Times, Jan. 18, 1995, at 1, col. 3.

26. Id.

27. Id.

28. L.A. Times, Dec. 30, 1994, at 1, col. 4.

29. Id.

30. Id.

31. Id.

32. New York Times, April 28, 1995, at 1, col. 2.

33. Id.

34. U.S.A. Today, Nov. 30, 1995, at 2B.

35. Id.

36. New York Times, Sept. 16, 1995, at 6, col. 6.

37. Id.

38. New York Times, June 4, 1994, at 1, col. 5.

Ms. Shannon is a Staff Attorney in the Enforcement Section.


The OC Register’s Editorial Board invited me to submit a brief editorial on a topic that should be discussed the next Tuesday for the first Presidential debate.  The submission was printed in their Sunday Commentary and titled “There’s no accounting of taxpayers’ money.”

No satisfactory annual audits? No consolidated financial reporting? No oversight committees? No performance measurements? I’m not talking about the liberal money grab known as Measure H, nor am I talking about the county of Orange circa 1994, although the similarities are certainly there. I’m talking about Washington, D.C.

Our president, the CEO of the largest employer in the nation, does not send his stakeholders an annual audited financial report detailing the benefits we received from our hard-earned federal tax dollars. We send in upwards to half of our earnings, between income and Social Security taxes, and we aren’t even given the courtesy of an accounting! So much for the Chief Financial Officers Act enacted in 1990!

Eleven of the 24 major federal agencies were unable to produce reliable financial statements for the fiscal year 1999. Although these departments are to obtain annual audits, a dozen of them did not receive a clean opinion from their outside auditors. There is no way of providing a consolidated audited financial statement under these circumstances.

Congressman Chris Cox has done his best every year to compile and send a summary U.S. Government Statement of Revenues and Expenses to his constituents. This is an admirable task as numerous sources must be contacted to collected and assimilate the data. As a certified public accountant, I want to commend Cox: He wants to see a balance sheet, he wants to reduce the debts and he wants to cut expenditures.

Every California municipality annually prepares its financial statements and has them audited by independent outside auditors. It allows those running the municipality to know they are solvent and running efficiently. Not so for the United States of America.

That’s why it is so easy for a U.S. president to send $1 billion here and spend $10 billion there. There’s no accountability! With no annual financial reports, who can complain?  With no annual actual-to-budget comparisons, who can make the appropriate cuts? Without year-to-year comparisons, who can determine trends? And who is to know about corruption?

The technology is here. The expertise is available. Where are our financials?

What are you hiding, Washington, D.C.? And what are you going to do about it, candidates for Congress and the White House?