Dangerous Derivatives: The Case of Orange County

5/3/2019 - Monocle Journal

Robert Citron was far from anyone’s idea of a typical financier. He did not own any well-tailored suits and he avoided visiting New York. He wore turquoise Navajo jewellery and scribbled endless notes on loose pieces of paper. He hated taking holidays and spent weekends at home with his wife on their modest ranch. He ate lunch almost every day at the same place, the Santa Ana Elks Club, where he used his wristwatch calculator to tally the bill. His car horn played the anthem of the University of Southern California’s (USC) football team. Yet, for 24 years he served as treasurer of Orange County, California, and he was generally believed to be something of an investment wizard, earning the local government millions of extra dollars through exotic investment schemes. Until December 1994, that is, when he lost $1.64 billion on derivatives, causing Orange County to file the largest municipal bankruptcy petition in history at the time.


Orange County


Citron had found himself in the position of county treasurer quite by accident. He had initially worked as a tax collector and, in time, rose to the top position in that department. In 1973, however, Orange County made the decision to merge the offices of the tax collector and the treasurer, and Citron suddenly found himself responsible for not only collecting money on behalf of the local government but allocating and investing it as well. And for many years, he did exceedingly well in his position. Citron began by buying bonds with government money, which were used as collateral for cash loans from Wall Street lenders, which were, in turn, used to fund the purchase of more bonds. This ultimately enabled him to offset the short-term interest he had to pay on the cash loans with the long-term interest earned on the bonds. With recession pushing interest rates down in 1991, Citron borrowed more cash and used it to buy more complex securities, including a novel derivative known as a step-up double inverse floater, which he was introduced to by Merrill Lynch bond salesman Michael Stamenson. Stamenson conveniently forgot to mention that the US Securities and Exchange Commission had recently warned just how risky such investments could be. And Merrill Lynch was even good enough to grant Orange County billions of dollars of credit to ensure it could buy as many of these securities as possible.

Fixed rate bonds are separated into two classes, floaters and inverse floaters. The coupon payments that are made on each are directly linked to the interest rate, rising and falling in accordance with the interest rate in the case of floaters, and in the opposite direction in the case of inverse floaters. The coupon payment rates on inverse floaters are calculated by subtracting the interest rate from a constant value each day. Should the interest rate increase, the deduction is greater, and the coupon payment decreases, whilst if the interest rate decreases, coupon repayments increase. Inverse floaters carry a high degree of interest rate risk and are considered to be volatile investments, and in the case of Orange County, the risk was made even higher by the fact that the county’s portfolio was leveraged using reverse repos. Through reverse repos, the county sold securities in its portfolio to Merrill Lynch and other Wall Street lenders for cash, agreeing to repay the principal cash amount together with interest upon repurchasing the securities at the end of the term of the reverse repos. The cash the county obtained was then used to further leverage its account and purchase more inverse floaters. The securities were therefore essentially used as collateral for margin loans to Orange County, an arrangement that was made precarious by the unmatched terms of the loans and the collateral – Orange County was obtaining money from short-term reverse repo loans and using this to purchase longer-term derivative securities.

For a short time, Citron’s gamble paid off and the county reaped the rewards. In fact, his new assistant Matthew Raabe feared that the county was recording rates of return that were too good and worried that this would make investors nervous, tipping them off to the high-risk nature of the investments. Citron and Raabe thus decided to divert some of the interest away from the county’s city and school funds and into the county’s general fund so that the earnings seemed to stay at a lower, less suspicious rate. But in 1993 interest rates began to rise and continued to do so into 1994, and the value of Citron’s highly-leveraged and highly-risky securities began to decline rapidly. The county had to post additional securities as collateral to make up for the decrease in value, and the liquidity of the county’s fund became significantly compromised.

Wall Street firms lending to Orange County panicked, selling the county’s collateral at an extremely low price. Orange County lost $1.64 billion and Citron was forced to resign, pleading guilty to six felony counts that included lying to investors and falsifying financial records. But despite the severity of the charges he faced, Citron was only fined $100 000 and sentenced to one year in jail. Somehow, he had managed to convince the court that he was, in fact, the victim in the case.

Orange County sued Merrill Lynch for $2 billion and when called to testify before the California Senate Special Committee on Local Government Investments, Citron and Stamenson battled for the role of the victim, each trying to avoid taking responsibility for the calamity that had befallen Orange County. Merrill Lynch remained steadfast in its belief that the bankruptcy was Citron’s fault, with Stamenson testifying that Citron had appeared to be a highly experienced investor who made sophisticated decisions. Stamenson, according to his own testimony, was just doing his job and selling his company’s products – it was not up to him to make decisions on his client’s behalf. He had assumed that Citron was well-aware of the risks that were attached to the investments he pursued. Certainly, Citron had been making some bold moves – but, then, surely the investment wizard had known something that he, a simple salesman, did not.

Citron countered Stamenson’s argument by claiming to have had very little insight into the decisions he made as county treasurer. “I wish I had more education and training in complex government securities,” he said and his lack of qualification for the job he had performed for over two decades soon became abundantly clear. He had no background in accounting or investing. He had never graduated from USC. In fact, his lawyer revealed that tests showed that he had a mathematics capability equal to that of a grade seven pupil and confirmed that he was in the bottom 5% of the population in terms of his ability to think and reason. Moreover, he was showing signs of advanced dementia. This, according to Citron’s lawyer, was a man who had tried to do his best in a job he was wholly unqualified to perform. He had relied on the advice of the people he trusted – most importantly, the investment bank guiding his decisions – and he had been purposefully led astray.

Ultimately, Merrill Lynch settled and paid $400 million to Orange County to end the legal battle, but the firm remained adamant that it had not misled anyone, and that it had always operated with the utmost integrity. Citron, meanwhile, was allowed to serve his one-year prison sentence on a partial basis, working at the prison during the day processing prisoner requests for personal items and returning home in the evenings. He lived a quiet life thereafter, doing volunteer work and attending as many USC football games as possible, whilst battling the depression that friends reported had taken hold of him ever since the Orange County case. In 2013, at the age of 87, he died of a heart attack.

Whilst there is no doubt that the case of Orange County highlights the importance of ensuring that adequate background checks are performed before appointing people to senior positions, the testimony provided by Citron and Stamenson revealed a problem that is far wider than the losses accrued by the county treasury. Merrill Lynch and other large investment banks like it were selling derivatives en masse during the 1990s – by 1996 the derivatives market was worth $55 trillion, by 1998 it had grown to $70 trillion, and in 2008 it was worth $600 trillion, according to the Bank for International Settlements. The reason these investment banks were successful at selling such complex financial instruments was because of the conveniently poor distinction that existed between a client and a counterparty. Investment banks exploited the implicit trust that their “clients” placed in the renown of their brands. These banks profited off the fact that their clients did not seem to fully understand that the bank was taking precisely the opposite economic stance to them in the trades that were constructed. Going forward, legislation such as the Fundamental Review of the Trading Book (FRTB) will attempt to improve transparency by eliminating troubling ambiguities like this.


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