MOORLACH UPDATE — LOOK BACKS — January 18

It’s been quite some time since I’ve sent you an Update that was strictly Look Backs, but the fun I was involved in ten years ago garnered significant media attention and was an outstanding learning experience.  Throughout this episode, I tried to be direct, candid, and transparent.

FIVE-YEAR LOOK BACKS

January 17

2001

The Associated Press covered the story of the County holding Edison International (parent company of Southern California Edison) short-term paper, but got it wrong in the first sentence, in “School fund investment in Edison hurts OC pool rating.”  Although the County did not lose one penny, this was a great example of what we call “media risk.”  I had informed the County’s CEO at the time, Michael Schumacher, about our holdings many days in advance.  Now I was providing a memo to the Board of Supervisors.  In retrospect, the memo and my quotes were spot on.  I also took all calls from the media and did not dodge any request for an interview.  Here are a few selected paragraphs:

                Six years after its historic bankruptcy, Orange County invested $40 million in struggling Southern California Edison, a move that has now led to a downgrade in the county investment pool’s credit rating.

                Treasurer John M. W. Moorlach said he invested the public school funds in Edison even though the utility had publicly acknowledged it was in trouble.

                Moorlach . . . alerted the Board of Supervisors in a memorandum late Tuesday that he invested $20 million in September and another $20 million in December.

                “It is our opinion that while there is a remote potential of a delay in receiving payments at maturity of these securities, there will not be any loss of principle,” Moorlach said in the memo.

                Fitch’s decision to downgrade the schools’ fund credit rating came after Edison notes fell Tuesday to junk-bond status when the utility defaulted on nearly $600 million worth of payments.

                “It’s impractical for the state to let Edison go into bankruptcy,” Moorlach said.  “I feel comfortable we will get our principal and interest.”

                The county treasurer initially invested $20 million Sept. 28 in a medium-term note after Edison publicly acknowledged it was paying more for electricity than it could charge customers.  That note matures July 18.

                He invested another $20 million in a short-term note on Dec. 7, three weeks after Edison said it needed a 10 percent rate hike and the ability to set its own rates to avert a financial disaster for the utility.

                On Tuesday, Moorlach defended his decision.

                “At the time, we did not believe the state would let the situation devolve to where it is right now,” Moorlach said.

                Board Chairwoman Cynthia P. Coad said she hadn’t had time late Tuesday to digest Moorlach’s memo but praised him for informing the board of Fitch’s action.

                “John’s got a handle on it.  I have confidence in him,” she said.

Jean O. Pasco and David Haldane of the LA Times provided their story in “O.C. Schools’ Investment in Edison Drops Credit Rating.”  They also made the same gaffe in their opening sentence.  As it parrots the AP article above, I’ll provide the first three paragraphs.  Just to repeat, Edison International has a number of subsidiaries, including Southern California Edison, and was a strong credit.  Mistaking one for the other was a sad, but understandable, journalistic error.

Orange County invested $40 million in public school funds over the past 3 1/2 months in the struggling Southern California Edison, actions that triggered a downgrading Tuesday of the county investment pool’s credit rating.

County Treasurer John M.W. Moorlach, who as a candidate warned of the county’s risky investments before its historic 1994 bankruptcy, invested the money even though Edison had publicly acknowledged its financial difficulties at the time.

In a memo late Tuesday, Moorlach alerted the county Board of Supervisors that he invested $20 million in late September and another $20 million in early December.

2006

Jonathan Lansner of the OC Register tracks the property tax collection statistics maintained by the Orange County Treasurer-Tax Collector for his quarterly “Big Orange Index.”  Trends occurring five years ago caught his eye in “Late taxes hint at housing’s toll.”  The disturbing trend was evident; it was also one of my themes in running for OC Supervisor.  A cataclysmic event was on the horizon as real property tax revenues would be declining, while pension plan costs would be rising.  One of the things you learn in managing money is that “the trend is your friend.”  About a year later, in my swearing in remarks, I requested my colleagues to prepare for ever-tighter budgets in the future.  It is fortunate that the County started early in this regard.  The entire column is a great read, and has a prescient feel, so it is provided in full below:

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A yellow warning light is shining on the Orange County real estate market’s dashboard.

The number of delinquent property tax payments has reached the highest level in a decade.

This worrisome trend may be evidence that high purchase prices and burgeoning payments on popular adjustable mortgages as interest rates rise may finally be taking a toll on the budgets of local property homeowners.

Orange County’s tax collector reports that:

Almost 46,000 property owners had not paid as of Jan. 7, a group that’s grown 15 percent from the same time a year ago. It’s also the largest count since the December 1995 bill.

These laggards – equal to 5.6 percent of all taxpayers – include residential and commercial property owners.

Late payers owe $83 million to the county government- a sharp 35 percent jump in late bills from 2005.

That overdue sum equals 4.3 percent of the total tax dollars owed.

John Moorlach, the county’s treasurer and tax collector, wasn’t totally surprised by the increase in late bills. A strong regional economy and rising local property values made delinquent bills a relative rarity in previous years.

Such nirvana is an economic script that cannot last forever.

"The trend had to break," Moorlach says.

Missing the tax deadline is a painful mistake. The county charges a 10 percent penalty on the amount that’s late.

Folks paying that penalty are clearly the small fry. The current late payer owes on average $1,800 for this installment – well below the average $2,300 for all property tax bills due this year.

Moorlach is troubled by what he called a "remarkable" $21 million jump in delinquent payments from last year’s $62 million. That’s noteworthy inflation even in a town with eye-catching real estate appreciation.

Still, he tries to be optimistic. He notes that December’s late bill-paying pace runs below 15-year averages—a period that includes the dark economic days of the early 1990s.

"As we say in our economic research, are we observing the beginning of a trend or is this a blip?" he asks.

WAIT FOR APRIL


If you recall, Moorlach has got a pretty good nose for impending financial doom.

In 1994, he shouted warnings about the county’s high-risk, idiotic investment schemes. Nobody listened and the county government ended up in bankruptcy court.

In the current tardy-tax scenario, Moorlach is clearly anxious about the surging late payments. But he’s reserving the right to get real nervous until he sees how many folks fail to make the second tax installment, due April 10.

More importantly, Moorlach notes, "offsetting this ‘disturbance in the force’ are the statistics for the second installment."

He’s heartened by the fact his office has already collected 14.4 percent of the money due for that second installment. Through Jan. 7, that’s an extra $35 million paid—or an 11 percent jump—in early payments vs. last year.

Some taxpayers choose to pay early to get income-tax deductions sooner. Moorlach, an accountant by training, speculates that this year’s early-bird surge comes from even more taxpayers trying to beat tax increases caused by the federal Alternative Minimum Tax.

No matter what the motivation, it’s remarkable to see enough Orange Countians with a total of $275 million in spare cash to pay a big bill well before it’s due.

WHAT’S A FORECLOSURE?


Warning: I do not claim to be saying that these late property tax bills are irrefutable proof that housing’s much debated "bubble" is now ready to burst into falling prices.

Do not expect the tax collector to have a slew of repossessed homes for sale at his next auction.

It takes about five years of legal maneuvers before the tax collectors can gain control of a home with delinquent taxes to sell it and pay off the old debts.

These days, virtually everybody finds a way to pay back the county.

Moorlach notes that his last auction in December had just two properties—both undeveloped land—up for bid. That’s a stark contrast to the ugly days of the 1990s when he sold off over 100 at every auction.

Bad memories aside, real estate’s other early warning signals aren’t blinking yet.

Orange County’s lenders have only slightly picked up the pace of official warnings sent to late mortgage payers. These default notices are the first step toward foreclosure.

In the year ended in November, lenders filed 3,041 default notices—up 9 percent from the previous 12 months but well below the 19,883 filed in 1996, toward the end of the local housing slump.

Hot real estate values get even the most troubled borrower out of their mess. They can refinance away a bad loan. Or they can sell and pay off angry bankers – and probably pocket a nice profit in the process.

That’s why Orange County had an amazingly small count of 120 foreclosures in the year ended in November—down four from the year before. As a healthy perspective, let’s recall that bankers retook 6,812 Orange County homes in 1996.

So don’t bet on a flood of distressed properties hitting the market any hour soon.

But it’s fair to assume that numerous households in this town are struggling with the high cost of housing.

The growing flock that’s skipping the tax bill proves it.

January 18

2001

As the energy crisis and its impact on the state’s utility companies had now become a front-page news item, the stories kept coming.  Sam Zuckerman of the San Francisco Chronicle wrote “Utility Bankruptcy Could Cause Havoc—Creditors may lose big in power crisis.”  His piece puts the potential magnitude of the situation in perspective.  Up until this point, many of us, including myself, had assumed that Governor Davis would resolve the issue.  This crisis revealed that Davis was not a competent leader.  His strength was fundraising.  When the leaders of the utilities came to pay Davis a visit, he blocked them because they had not made significant contributions to his re-election campaign.  Consequently, Davis turned a problem into a mess and built the case for his eventual recall, becoming only the second Governor in U.S. history to be recalled.

Financial shock waves will be felt far and wide, from the nation’s largest banks to schoolchildren in Orange County, if California’s two big electric companies file for bankruptcy.

Southern California Edison and Pacific Gas and Electric Co. filings would be the largest and third-largest bankruptcy cases, respectively, in U.S. history, involving a combined $20 billion in debt.

Creditors, especially ones whose loans aren’t backed by collateral, would face potentially irrecoverable losses. And the ripple effects from the bankruptcies would shake markets around the world, analysts say.

"Either one of these would be a huge case by itself," said Lynn LoPucki, a law professor at the University of California at Los Angeles. "Together, they surpass anything we’ve ever seen. This is putting more creditor dollars at risk than any bankruptcy in history."

Edison and PG&E are selling electricity at prices far below their costs, a situation they say will force them to seek court protection from their creditors within weeks unless political leaders bail them out. The danger was highlighted in the past few days as the two companies defaulted or said they would default on hundreds of millions of dollars in debt coming due.

The list of creditors owed money by the utilities is long. It includes power suppliers, banks and thousands of institutional, governmental and individual investors who hold bonds or other debt securities.

The outcome of bankruptcy is uncertain since a solution to the utilities’ business problems depends on political action. A state or federal bailout could save the utilities, but there is no guarantee that it would protect the interests of creditors.

"If there is a political rescue, there could be enough money to keep the utilities operating," said LoPucki. "But if it’s just enough to keep them operating and no more, that wipes out the debt holders."

The trauma of bankruptcy would be compounded by one overriding fact: Utilities, unlike, say, casinos or airlines, aren’t expected to renege on their debt.

"It’s an extremely rare thing," said Jacob Mercer, a utility debt analyst at US Bancorp Piper Jaffray. "Only two publicly traded electrical utilities have declared bankruptcy since the Great Depression, and both of those involved nuclear power."

Among those who could be hit hardest are individual investors, who don’t have the resources to diversify their portfolios. Mercer said he has fielded frantic calls from small-time investors who bought utility bonds to play it safe. "There are lots of ma’s and pa’s who own these bonds,” he said.

In the days before California’s power market was deregulated, utilities had captive markets and guaranteed profits. Their bonds and other debt securities were considered among the safest places to put money.

"These are the kinds of investments you sold to widows," said Orange County Treasurer John Moorlach. "Utility companies were no-brainers."

Orange County is already one of the victims of the utilities’ financial plight. The bond rating service Fitch downgraded the county’s school investment pool yesterday because of its vulnerability to a utility default.

Orange County holds about $40 million of Edison debt securities in a fund that supports local school operations, representing about 3.3 percent of total assets. If the county’s entire Edison investment were lost, the yield in the school fund would be cut from more than 6 percent to less than 4 percent, Moorlach calculated. That would cut to support local schools by millions of dollars.

There is a special irony to Moorlach’s dilemma. Orange County itself went through a bankruptcy crisis in the mid-1990s because of investments that went sour. Moorlach was elected county treasurer on a platform that stressed prudent investment management.

Moorlach said he bought Edison debt securities precisely because he considered it safe. "We buy prime paper only," he said. "We’ve been very cautious."

Banks, for their part, have lent about $2.2 billion to PG&E and Edison, the brokerage firm Salomon Smith Barney estimates.

Bank of America, the nation’s third-largest bank, led a group of financial institutions that extended an $850 million credit line to PG&E last year, while J.P. Morgan Chase, the No. 2 bank, was leader on a $1 billion Edison credit.

Defaults and downgrades by debt rating agencies have put the utilities out of compliance with terms of the loans, making the credits immediately due in full, bankers said.

Bank of America and Morgan Chase declined to comment on their loans to the California utilities. BofA’s Chief Financial Officer James Hance told analysts earlier this week that the bank projects that it will write off $3 billion in delinquent credits in 2001 and that amount should cover any bad loans to utilities.

Most big institutions say they have diversified their holdings to avoid being hurt by bankruptcies. The California Public Employees’ Retirement System has just a little more than $8 million of PG&E and Edison debt in its $46.6 billion fixed income portfolio.

Utility bankruptcies "are not going to bring us down," said spokeswoman Pat Macht.

One special area of concern is money market mutual funds, considered one of the safest investments because they promise investors that they will try to keep shares at $1.

Standard & Poor’s analyst Peter Rizzo said he doesn’t expect any of the 400 money funds he follows to take a big hit, but some have had to scramble to unload California utility debt to keep shares at $1.

"None of our rated funds is in danger of breaking a dollar," Rizzo said. "But some of them had exposure (to Edison and PG&E) larger than 1 percent and there is only a 0.5 percent margin of error. They were getting out of this."

Meanwhile, PG&E and Edison debt securities have plunged in value, with bonds secured by real estate trading at 80 cents on the dollar, while unsecured debt fell to 50 cents. Analysts said few bonds are actually changing hands because buyers have become scarce.

"The problem is no one knows what these securities are really worth," said Jon Kyle Cartwright, a debt analyst with the brokerage Raymond James & Associates. "Under the existing situation, it is difficult, if not impossible, to value these companies."

As the above article points out, the Edison debt traded below par, also known as a recognized loss.  As Treasurer, I could have sold the County’s holdings and incurred a realized loss.  However, I felt strongly that the parent company would honor its debt and elected to hold until maturity, thus avoiding any losses.  This position was addressed by Bloomberg News reporters David Evans and Liz Goldenberg in their piece, titled “California Utilities’ Commercial Paper May Be Hard to Resell.”  Here is a selected quote:

                “I have a high confidence level that I’ll get paid, because some fair and equitable remedy will be provided by the state legislature to ensure the financial viability of Southern California Edison,” said John Moorlach, the treasurer of Orange County, southeast of Los Angeles.

The Daily Pilot provided its story in “District investments in Edison could spell financial trouble—School officials expect state to find solution” by Danette Goulet.  Here is a selected section:

                Despite the precarious position of the power company, [county Treasurer John M. W.] Moorlach said he expects the state will come to Edison’s aid and ensure the safety of the investments.

                “I feel confident that we will get our principal back,” he said.  “I believe at this critical juncture that the state has to remedy the problem.”

The OC Register, still smarting from missing the OC bankruptcy (my opinion), had some fun at my expense with “Stake in Edison not so bright?—County:  Moorlach asked to explain $40 million investment in the staggering utility,” by Martin Wisckol and Heather Lourie.  Again, the reporters erroneously referred to an Edison International investment as an SCE investment.  Here are selected paragraphs, including the opener and closer:

                An Orange County investment of $40 million in teetering Southern California Edison has prompted county Supervisor Todd Spitzer to call for a public hearing Tuesday in which Treasurer John Moorlach will be asked to explain his investment decision.

                A Fitch spokesman said it is highly unlikely the county would lose its investment, and politicians and school officials expressed confidence in Moorlach’s handling of the money.  But Spitzer said the situation merits closer scrutiny.

                “We were anticipating that there would be more cooperation from the state,” Moorlach said.  “We have a conservative approach here – we avoid tobacco, for example, because of the lawsuits.  If I had a crystal ball, I would have avoided (the SCE investment).”

                Government watchdog Bill Mitchell said the investment was of interest more because of the irony and curiosity than because of serious concerns.

                “It’s interesting, but is this a lapse of judgment by John Moorlach?” Mitchell asked rhetorically.  “No.”

By the end of a hard day of responding to all reporter inquiries, you can feel pretty beat.  Jean O. Pasco with the LA Times, and someone who I’ve known for years, caught me with my guard down, displaying a human moment, and wrote “Moorlach Feels Pain of School Losses—Treasurer says it’s ‘breaking my heart’ that $40-million Edison stake just turned into junk bonds.” Here’s the opening of the article:

Orange County’s financial chief said the uproar over his office’s decision to invest $40 million in school money in the battered utility market is "breaking my heart," and he conceded that every school district in the county could lose millions in future earnings.

County Treasurer John M.W. Moorlach said the twin $20-million investments in Edison International–one made Sept. 28 and the other Dec. 7–were viewed as solid moves by his office at the time, despite loud warnings then of a potential financial meltdown of Southern California Edison, the state’s second-largest utility.

The investments represent 3.3% of about $1.1 billion in the county’s educational investment pool, which holds excess operating cash for school districts. The pool was expected to earn 6.5% in interest this year.

The Edison notes fell to junk bond status Tuesday, triggering a downgrading of the county pool’s credit rating from AAA to AA status the same day.

Some school and county leaders expressed concern, even amazement, that Moorlach had invested school money in Edison, but said they had faith the notes eventually would be repaid. County supervisors and members of an oversight committee that was established after the county’s historic 1994 bankruptcy–caused by soured investments–indicated they will review the Edison investments next week.

Orange County could find itself waiting in line as a creditor if Edison files for bankruptcy. In such a worst-case scenario, the county would withhold interest payments to the districts for five months and use that money to replace the lost capital. The lost interest earnings for the districts could potentially range from $4.08 million at Garden Grove Unified to $3.89 million at Capistrano Unified. Any remaining interest would be distributed among the districts, based on the total amount each district has in the pool.

Moorlach said he learned of the Dec. 7 purchase of the Edison bonds a week after the investment. He said he hadn’t told his investment officers to steer clear of such market purchases because "my gut didn’t tell me it was necessary."

"In hindsight, that would have been easy to do," he said. "It’s breaking my heart to see this happen."

Robert Fauteux, chairman of the Orange County Treasurer’s Oversight Committee, said that while his panel was unaware of the purchases, they did meet the guidelines of the county’s investment policy.

"Hindsight is worth 20,000 pounds of foresight," said Fauteux, who was asked by Moorlach to chair the committee after it was formed in 1995 in the wake of the county’s $1.64-billion bankruptcy the previous year.

Fauteux said the panel, which meets Jan. 24, is charged with guaranteeing that investments meet county and state law.

Supervisor Todd Spitzer said he also will ask his colleagues next week to question Moorlach on why his office bought the Edison bonds.

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