Until 1994, Orange County, California was known for producing Richard Nixon, surfer boys, and Disneyland. No one ever said California was consistent. Described by a socialist magazine as a “fantasia of orange groves and McMansions,” Orange County was a place where, in the words of Ronald Reagan, all “the good Republicans go to die.” On December 6th, 1994, the county became known for being the first municipal casualty of investment malpractice. It reported a loss of $1.64 billion from its investment pool and announced the largest municipal bankruptcy in U.S. history. Twenty years later, and the county was still importing other people’s trash to pay off its debt. While Detroit and Jefferson County, Alabama have since eclipsed the Orange County bankruptcy in terms of numbers, nothing comes close to the wild investment tactics of its rogue treasurer, Robert Citron, or the $400 million-dollar tab Merrill Lynch was forced to pick up. Unlike Detroit dealing with decades of urban sprawl, or Jefferson County trying to plug a disastrous sewage problem (don’t ask), Orange County was a well-known destination municipality seemingly in robust health. It had a budget exceeding $3.7 billion dollars, employed 18,000 people, and was the fifth-most populous county in the United States at the time of bankruptcy. And, for over twenty years, its investment pool produced such dazzling yields — it earned an average yield of 8.52% as opposed to neighboring counties such as Los Angeles which earned 3.88% — that Robert Citron’s fame extended well outside the county, leading 99 external entities to voluntarily invest with the financial wizard. As Thomas Riley, then chairman of Citron’s Board of Supervisors, put it, “I don’t know how in the hell he does it. But he makes us all look good.”
As the municipal finance market is forecast to hit another rough patch, we’re taking a look back at Orange County’s bankruptcy, one of the most famous municipal defaults in modern history. Mad as Hell: Tax Revolts and the Aftermath of Prop 13 After the dust settled, Citron no longer had a posse of fawning admirers. He is often framed as the evil mastermind behind Orange County’s demise, but O.C.’s problems began long before his bizarre reign as treasurer and tax collector. In the 1970s, rising property taxes combined with double-digit inflation enraged homeowners in California. Some homeowners saw their property taxes nearly double in the course of a year, leading them to believe that California was, as widow homeowner Deloris McCormack described it, “an octopus just gobbling up all our little homes.” Galvanized by populist leader Howard Jarvis, now immortalized in his memoir I’m Mad as Hell, California passed one of the most sweeping tax reform bills in American history: Proposition 13. Prop 13 did two things: it convinced many Californians that raising taxes was a mortal sin, and it made many municipalities, such as Orange County, incapable of tapping their tax base during times of emergency. It started a new wave of state fiscal austerity that, in turn, led to more liberal investment rules for local governments to try to offset some of the revenue declines. A year later, during Citron’s extensive 14-year reign as tax collector, he was greeted with a swastika and tea bag, Orange County’s idea of a subtle warning not to raise taxes. Given the cash-strapped climate combined with an astounding lack of oversight, it’s unsurprising that he quickly moved beyond “plain-vanilla” securities and into riskier territories. Bob Citron & How To Lose Money on Derivatives Bob Citron was not a financial specialist of any variety. He’d formerly worked as a car salesman before joining Orange County’s tax department in 1960. A decade later, he’d risen to department supervisor and became the official “tax man.” In 1973, he was handed the dual role of Tax Collector-Treasurer after Orange County merged offices to save money. During his time as a public servant, Citron used to carry around a personal calculator to divvy up lunch bills at the local Kiwanis club. He was known for his discount suits, Navajo jewelry collection, and having a spat with the county over $12 dollars missing from his paycheck. But it was this Scrooge-like persona that made his Vegas-inspired investments all the more credible. The first thing Citron did after Prop 13 passed in 1978 was to draft a new law that would allow county treasurers to invest larger sums of money through leverage. Specifically, it permitted the use of reverse repurchase agreements, or “repos,” which allowed him to expand his asset base with borrowed money. At the height of his wizardry, Citron was earning a 17.7% return on his investments. In 1994, Citron was managing the Orange County Investment Pool (“OCIP”) with equity valued at $7.5 billion. The portfolio was a mix of customized structured products, interest rate swaps, and fixed income securities. After years of aggressive borrowing through reverse repos, Citron had expanded the pool to nearly three times its original size ($20 billion) in a continued effort to enhance returns. This pushed the debt-to-equity ratio up to 1.67. Essentially, Citron posted OCIP’s bonds to a number of Wall Street lenders, including Merrill Lynch, Goldman Sachs, and CS First Boston, in exchange for loans which he used to purchase more bonds. As long as the rate of borrowing remained below the investment rate and ignoring any marks to market, Orange County would make money. It was simultaneously a bet on the short-term interest he’d pay for the loans and the long-term interest he’d earn from the bonds. The chart below shows why, between 1990 and 1993, Orange County’s strategy of borrowing short-term and investing over longer horizons profited as the spread between two-year and five-year yields widened. Unfortunately, Citron’s aggressive investment strategy was heavily dependent on the whims of the Federal Reserve, the direction of short and long-term interest rates, and the cooperation of his partners and lenders. When asked by an investor how he knew interest rates would remain low, Citron responded, “I am one of the biggest investors in America. I know things.” The Chickens Come to Roost One thing Bob Citron didn’t know was that the Federal Reserve would raise interest rates not once, not twice, but six times over the course of 1994, hiking rates from 3% to 5.5% by year’s end. Bond values dropped and some of his bespoke investments now cost more than they earned, leading a number of anxious investors to demand their money back. Not everyone turned a blind eye to the magical returns of financial wizard Citron. In 1994, John Moorlach, a wholesome CPA who met his wife at Bible study, was encouraged by local Republican leaders to run against Citron for Treasurer-Tax Collector. Initially reluctant, Moorlach changed his mind after examining the contents of Citron’s investment portfolio. After receiving the list through a public records request, Moorlach faxed it to a number of bond and securities dealers for examination. “It was the worst portfolio they’d ever seen,” said Moorlach. “I felt sick. I thought, ‘Great. I’m gonna win, then two years from now, it’s going to blow up.’” Moorlach didn’t win. He didn’t even raise an eyebrow. Instead, he was dismissed by Citron as “Chicken Little” and told by county officials to stop eroding investor confidence. It was much easier to portray Moorlach as a zealous Republican intent on taking down the only elected Democrat in county government than it was to hear bad news. And on June 8th, 1994, Citron was reelected. Despite $1.64 billion in losses in 1994, Citron tried to stay the course, insisting that interest rates would fall again. But by year’s end, Citron was facing a full-on bank run. By the time CS First Boston made its collateral call in December and put its entire $2.6 billion stake on the market, OCIP’s available cash pool had shrunk from $1.5 billion to $350 million. Hoping to prevent further creditors from liquidating the collateralized securities, the county filed for bankruptcy protection (it didn’t stop them). Financial Lessons from My Mail-Order Astrologist The Orange County bankruptcy highlights the perils of a desperate government trying to outwit the market. As John Moorlach later remarked, “The economy controls what the government can do. When local government bureaucrats and elected officials believe they can rely on rosy economic trends, that’s when a fiscal calamity is just around the corner.” During the grand jury trial, it was revealed that Citron had routinely consulted a mail-order astrologist, psychic, and $5-dollar star-chart for interest rate forecasts. He also produced reports that confirmed his long developing dementia. Predictably, no party took responsibility for the fiasco. Citron tried to place the blame on Merrill Lynch, and vice versa. He claimed that he blindly followed the investment advice of Charles Clough, Merrill Lynch’s chief investment strategist, who forecast flat or declining interest rates for three to five years. The Board of Supervisors, Orange County’s flimsy semblance of an oversight team, pled ignorance and portrayed themselves as “good-hearted bumpkins who just couldn’t tell a derivative from a donut.” “We had no reason to doubt him,” said Supervisor Harriett Wieder. “What did I know about those investments? What did anybody know? None of us have ever heard of derivatives or reverse repos any more than you have.” Ironically, subsequent research revealed that had Citron’s lenders stayed the course, the county would have recovered its full portfolio plus $300 million in interest the very next year. Perhaps star charts are worth something after all. Orange County’s hasty bankruptcy declaration might have been prevented by state intervention to restore the county’s finances. Instead, the county took on $880 million more in debt and was stuck paying it off until 2017. Where Are They Now? Robert Citron spent a memorable year at the county jail processing toothpaste orders from inmates. He retired from the public eye and continued collecting his $92k pension until he passed away in 2013. “Chicken Little,” aka John Moorlach, rebranded himself as the “fiscal conscience of the CA legislature” and spent two decades cleaning up Citron’s mess before becoming a state senator in 2015. As for Orange County, it made the final payment towards the $1 billion bond it used to crawl out of bankruptcy in 2017. Prop 13, after 42 years in action, is once again up for amendment. By giving themselves a tax break, Californians inadvertently also gave corporations one. This coming November, Californians, at the advice of Mark Zuckerberg, vow to correct that oversight and to finally make Disneyland pay. About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at firstname.lastname@example.org.