MOORLACH UPDATE — Merry Christmas — December 22, 2012

The Second District wishes you a very Merry Christmas and a Happy New Year (from left to right are Ian Rudge, Cammy Danciu, Kathy Moran, Pamela Newcomb, Lindsay Brennan, myself, and David Mansdoerfer).

(Thanks to Cammy Danciu for her artistic talents.)

For a little humor, here is a slide from my January 24 “State of the County” address:

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Pamela Newcomb gave me a t-shirt yesterday that reads:  “I survived the end of the world – 12/21/12” (circling the Mayan calendar).  Thank you, Pamela!  But, getting a credit down grade is like the end of the world.  Here is another “State of the County” slide:

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The County received a minor rating downgrade from Moody’s.  The OC Register covers the decision below.  The article is self-explanatory, but it is interesting how Orange County, a “double-A, one” (top tier) issuer, would be impacted by the bankruptcy filings of the cities of Stockton and San Bernardino (and their conundrum between paying CalPERS or paying bondholders, which is currently being addressed in the Federal bankruptcy courts).  It is important to note that the OC is not issuing a long-term Pension Obligation Bond (POB).  The OC is only issuing an 18-month note, and for all the right reasons, to obtain a significant early payment discount from the Orange County Employees Retirement System (OCERS).  This cost savings strategy was initiated by myself and Patti Gorczyca, formerly of the CEO’s office, back in 2006, when I was Treasurer.  The County would be making these pension plan payments to OCERS as a regular biweekly payment with the county’s payroll, but will now be paying the trustee/custodian on behalf of the note holders.  If you’re looking for a short-term fixed income instrument that has a budgeted repayment schedule, here’s an investment you may wish to consider.  As an aside, it is also interesting to note that Moody’s is watching the top potential torpedo in my “State of the County” address, the potential VLF/property tax take by the California Department of Finance, as closely as we are.  This issue will carry over into next year, as well as the continuance and conclusion of negotiations with the County’s two largest labor unions.

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Moody’s cuts rating on county’s pension bonds

By ANDREW GALVIN

Moody’s Investors Service cut its rating on Orange County’s pension obligation bonds by one notch Friday, reflecting the rating agency’s changed view of this type of bond.

Each January, the county sells 18-month bonds to investors, using the proceeds to prepay a year’s worth of pension contributions to the Orange County Employee Retirement System.

By prepaying, the county gets a 7.75 percent discount on what it pays OCERS, said Bob Franz, the county’s interim CEO. Last year, the county found investors willing to take the bonds for about 0.8 percent interest, so the county nets significant savings, he said.

Next month, the county plan to sell $268.5 million in pension obligation bonds, saving $19 million on its pension payment after the discount for prepayment, less interest and the cost of issuing the bonds.

Moody’s said it believes pension bonds are less secure than prior estimates. Franz said Moody’s officials told him the changed view applies to all issuers of such bonds.

Based on conversations Franz had with Moody’s officials in San Francisco recently, Franz said the implication was that in recent municipal bankruptcies such as Stockton and San Bernardino, "pension debt is being viewed differently by issuers in terms of obligation to pay under bankruptcy."

As a result, Moody’s is rating all pension bonds two notches lower than the issuers’ general obligation rating, Franz said. Orange County’s pension bonds were cut from Aa2 to Aa3, while its issuer rating remains at Aa1.

Franz said the change shouldn’t affect the county’s borrowing costs when it sells pension bonds next month. "If they treat everybody the same with this two notch differential, then it shouldn’t make any difference to the investors," Franz said.

However, Moody’s maintains a negative outlook for the county’s debt ratings, meaning they could be revised down in the future. This is partly because of uncertainty over the county’s coming face-off in court over $73.5 million in annual tax revenue the state says the county owes.

"I think that’s an honest concern," said John Moorlach, chairman of the Board of Supervisors.

A trial date for the state’s lawsuit is set for next month.

Moody’s officials couldn’t be reached for comment late Friday afternoon.

FIVE-YEAR LOOK BACKS

December 21

2007

Ronald Campbell of the OC Register continued with the Treasurer theme in “O.C. treasurer Street tripled stake in controversial investments – Chriss Street is alone among county treasurers in relying on ‘structured investment vehicles.’  Experts question appropriateness.”  It reminds me of a phrase, “you manage an investment, you do not marry it.”  When an investment strategy is no longer appropriate, then back out.  This was the probably Citron’s biggest mistake – not disengaging from the carry trade, when almost everyone else in the industry had done so.  This article provides a primer on SIVs, with the last paragraph summing up this chapter on an asset-backed commercial paper, that morphed into an awkward investment vehicle, with the full backing of the credit rating agencies (who were paid handsomely, I’m sure, for their ratings).

Soon after taking office, Orange County Treasurer-Tax Collector Chriss Street nearly tripled the county’s stake in controversial securities that other local governments avoid.

The securities, known as structured investment vehicles or SIVs, almost cost Street his investment powers this week. County supervisors voted 4-1 Tuesday to let Street continue investing the county’s spare billions – but they ordered a consultant to weigh the risks of his bets.

Street says the SIVs are safe and secure. He also says they’re old news: The county began buying them at least six years ago under his predecessor and principal critic, Supervisor John Moorlach.

However, an Orange County Register review shows that the county’s investment in SIVs ballooned after Street took office Dec. 5, 2006.

They comprised 4 percent to 5 percent of the county’s $6 billion investment pool from 2003 to 2006. Today SIVs account for 14 percent.

"I didn’t know he’d gone up so aggressively after I left," Moorlach said.

Street was buying while other big investors were getting nervous. By July 30, when the county bought its last SIV, heavy losses on mortgage-backed securities had given some on Wall Street a severe allergy not just to mortgages but to all types of asset-backed securities, including SIVs.

The only other major California county that bought SIVs, San Diego, cashed in its last one on Nov. 7. It never had more than 1.25 percent of its portfolio in SIVs.

The investments came under fire earlier this month when Moody’s Investors Service threatened to downgrade more than half the SIVs in Orange County’s portfolio. A downgrade would have undercut the value of those securities, for which the county paid $460 million.

Citigroup and Netherlands-based Rabobank subsequently agreed to take most of the SIVs onto their books, giving them their own gilt-edged credit rating. Just one issuer in the county portfolio remains under threat, and its sponsor is planning to restructure the SIV to avoid a downgrade.

Because of the big banks’ maneuvers, Street told county supervisors Tuesday, the SIVs may be better investments now than when he bought them.

"By luck of the draw, he’s right," said Joseph Mason, a SIV expert and finance professor at Drexel University in Philadelphia. "That still does not justify his activity."

The investments are legal under the county’s policy, which permits the treasurer to buy a variety of securities, provided they have very high credit ratings – as all of the SIVs do.

The county policy is generally conservative. The county can’t buy stocks or real estate. It can’t invest more than 5 percent of its assets in any one issuer, except the U.S. government and government-sponsored enterprises such as mortgage giants Fannie Mae and Freddie Mac.

Nor can it borrow money to invest, a tactic that landed the county in bankruptcy 13 years ago.

The bottom line is that the county can take few risks and consequently cannot earn high returns.

In November, the money market funds that Street manages for the county and local schools earned 5.05 percent and 5 percent respectively. His extended fund, which invests money for 13 months to five years, earned 5.35 percent.

To put those numbers in perspective, you can earn as much as 5 percent on a 1-year, $1,000 certificate of deposit.

By those meager standards, SIVs are stellar investments. The SIVs in Street’s portfolio pay from 5 percent to 5.5 percent, ranking them among his better securities.

Street told supervisors Tuesday that he invested in SIVs to diversify away from Fannie Mae and Freddie Mac, reducing the county’s stake in the troubled U.S. mortgage market. His SIVs hold assets like bank debt, overseas mortgages and credit card receivables.

"The best choice for diversification were the SIVs," Street said.

Here’s how a typical SIV works:

A bank bundles high-interest assets like commercial loans, auto loans and credit card receipts into a pool. Institutional investors such as Orange County provide the funding to create the pool in exchange for the promise of being repaid with interest after two to three years.

The pool’s managers borrow money for two to three months at a time to cover the cost of replacing the fluctuating assets in the pool, for example when car loans and credit cards get paid off. As long as the pool managers can borrow money at lower interest rates than the assets pay, the bank and investors all make money.

At first glance a SIV looks like a perfect deal for both the bank and the investors. The bank moves assets off its balance sheet, making it look stronger on paper, but still gets paid to manage those assets. The investors get top-A rated securities that pay better interest than most highly rated securities.

"Invariably," SIV expert Mason said, "the investors claim they were attracted by the high yield and were told they were risk-free."

Moorlach agreed: "You almost got the sense you would always get paid," he said.

The perfect deal broke down late this summer when the Wall Street mortgage panic spread to other types of asset-backed investments.

SIV managers no longer could get cheap short-term loans. That endangered the SIV’s credit ratings. Rather than face angry investors, banks took the assets back onto their books.

The banks didn’t have to take the SIVs back, Mason said. The SIV assets were, after all "off the balance sheet." That means they weren’t the bank’s responsibility.

One of the lessons here, Mason said, is that "ratings don’t mean what we thought they meant, and we shouldn’t be surprised by our predicament."

December 22

2002

Jean O. Pasco of the LA Times did a similar theme as the OC Register’s December 20 piece with O.C. Planning Crisis Recalls ’94 Bankruptcy – Some critics say the same flaws have arisen in the agency’s losses of $1 million a month. ‘It’s deja vu all over again,’ says Moorlach.”  Here it is in full:

A department suddenly bleeding millions of dollars. County supervisors blindsided. Finger-pointing over who should have known what and when.

This has been the scene at the Orange County Planning Department, which has lost $8 million over the last six months and in the last two weeks has laid off 20% of its staff and proposed hefty increases in building-permit fees.

To some officials, the situation bears a troubling resemblance to a calamity that county officials hoped was just a bad memory: the 1994 bankruptcy.

That collapse, caused by risky investments by then-Treasurer Robert L. Citron, resulted in a dramatic remaking of Orange County government that was supposed to emphasize audits, the hiring of a tough chief executive officer and stricter oversight of far-flung departments.

Now some wonder whether these reforms really worked.

"It’s deja vu all over again," said county Treasurer John M.W. Moorlach, who raised concerns about Citron’s investments before the bankruptcy and was later appointed to replace him.

"You find yourself asking the same questions: How did the money disappear so fast? Where was the internal auditor? Where was the budget analyst? There are so many lines of defense that it seems inconceivable."

Both the Board of Supervisors and top county executives came under harsh criticism after the bankruptcy for not monitoring Citron closely. In fact, supervisors often praised the treasurer for the high returns he got on the public’s money. They later discovered he was using risky investment schemes that resulted in a $1.67-billion loss.

Moorlach and others said the same failures are apparent eight years later in the Planning Department.

The planning director, Thomas B. Mathews, frequently won accolades for the efficiency of his shop and his ability to balance the interests of developers and environmentalists. But as the economy cooled in recent years, revenue from building permits dropped dramatically. Instead of cutting costs, planners predicted an uptick in development that never materialized.

In August, the Board of Supervisors made an emergency allocation of $8 million to keep the department afloat. But by this month, the department had exhausted the money and was losing up to $1 million a month. The latest blow came Friday, when a judge ruled that the department misspent $12 million, requiring officials to come up with money they don’t have to set things straight.

Mathews, 57, announced his retirement last week.

William Popejoy, the former business executive brought in to run the county after the bankruptcy, questioned why top county officials — notably County Executive Officer Michael Schumacher — didn’t intervene earlier, and why they didn’t question the Planning Department’s rosy forecasts.

"His office should have brought this to the attention of the supervisors early on," Popejoy said. "Mike’s responsibility is to raise red flags with the supervisors and then go to the department and start to squeeze. It’s a problem of accountability. And frankly, the buck stops with the CEO."

Schumacher, who wouldn’t comment for this story, unveiled a recovery effort for the Planning Department last week that included a full audit, a new interim director and the development of more accurate forecasts.

Still, some supervisors said they were blindsided by the problems at the Planning Department and still believe they don’t have all the facts.

"The whole thing should have been stopped months ago and rectified," said Board of Supervisors Chairwoman Cynthia P. Coad. "The community needs to stay on top of this."

To some officials, the reforms made after the bankruptcy might have exacerbated the problems in the Planning Department. To make the county run more like a business, the supervisors in 1995 created the position of CEO and ceded it much of the oversight of county departments. Now the CEO — not the supervisors — directly oversees budgeting, hiring and firing.

The setup, which was designed to depoliticize the bureaucracy, left department managers with more autonomy and less direct oversight, said Shirley Grindle, a longtime campaign-finance activist.

Tricia Harrigan, who monitors board meetings for the League of Women Voters, said the supervisors now face a critical choice: Either they take back greater oversight of county departments or demand that the CEO do more.

"This looks to me like a failure of the CEO system," she said.

Moorlach said the bankruptcy has focused so much attention on investment issues that other issues go unchecked.

"When you have the majority of your police force focusing on one house, the burglars are going to go elsewhere," he said.

2007

Dana Parsons, columnist for the LA Times, was back with “As showdowns go, this was a one-way Street.”  To read the editorial that Parsons refers to, see MOORLACH UPDATE — OCMA — December 14, 2012.  Here is the Parsons piece in full:

John Moorlach insists he wasn’t cowed. Still, I kept waiting for him to lay into Orange County Treasurer Chriss Street. And if things really got going, maybe challenge him to a duel in the Board of Supervisors chambers. Perhaps walk over and slap him with a white glove.

But, nope, Supervisor Moorlach just sat there last Tuesday like a mild-mannered gentleman, as if unaware that Street, his former brother-in-arms, had royally trashed him in recent days. He quizzed Street as he might any other department head or elected official — with respect and civility. For a minute there, I thought he might ask him to lunch.

There’s no enmity like brother-on-brother. From the Book of Genesis down through Shakespeare and Steinbeck, writers have recognized the passions that erupt when brothers fight.

Street and Moorlach were the closest of political blood brothers. Their interlocked fates have been well chronicled — how they sounded alarms about county Treasurer Bob Citron’s investment strategies in 1994, only to be ignored but later vindicated when the portfolio blew up and bankruptcy ensued. How Moorlach succeeded Citron, later appointed Street an interim assistant in 2006 and then endorsed him in that year’s election.

Then came the rift.

Street is the subject of local and federal investigations related to actions before and after he won election last year.

He hasn’t been charged with anything, but Moorlach has led the effort to strip him of his authority over the county’s $6 billion investment pool. In so doing, he has questioned Street’s fitness as a public official.

As the controversy unfolded, virtually all of the shots had come from Moorlach. Street had been left to fend them off.

Then came a Dec. 14 column he wrote for the Orange County Register. In it, Street unloaded on Moorlach and county employee’s union head Nick Berardino. "Speaking as one, these politicos manipulate and publicly misrepresent complex financial transactions in an effort to whip the public into a frenzy," Street wrote. "There is no basis for this reckless demagoguery."

Street’s essay followed criticism after his disclosure that some "structured investment vehicles," or SIVs, in which he’d invested were on credit watch by a financial ratings agency. Street pointedly said that Moorlach went through much the same thing during his tenure and had even advocating buying some securities on credit watch.

After recounting their better days together, Street wrote, "Today, I wonder where that old friend, the man who held principle above politics, is hiding." He went on to say, "I have lost my old friend John to the allure of ambition and the pragmatism of politics."

In case the point hadn’t been made, Street concluded his essay by saying Moorlach and Berardino’s actions "transcend politics; they betray the public trust."

Ouch, babe.

Later that same day, in a public forum explaining the SIV situation and his investment strategy, Street noted that managing a portfolio "is not for the faint of heart, and it is not for those who want to rest on past laurels, while pontificating like a Monday night quarterback."

Talk about getting something off your chest.

That brought us to Tuesday’s Board of Supervisors meeting, in which I expected Moorlach to defend his honor, just four days after being torched.

Instead, he queried Street about his willingness to commit a significant percentage of the portfolio to SIVs when other entities were backing away from them. He also asked a couple of other inside-baseball questions that had, at most, a subtle bite to them.

Not a raised voice. Not a stinging barb. Nothing to match even remotely the smoke coming from Street a few days before.

I asked Moorlach if Street’s broadsides had scared him off. After saying no, he added, "I have this difficult problem of trying to surgically remove this guy without panicking the whole world."

He said he could rebut Street’s published critiques, but in a larger sense took them as "deflections" of the real issues — namely, the SIV controversy.

Still, Moorlach agreed he’d been "gentlemanly" in his discourse with Street. "I think we should put on a good public face," Moorlach said. "We [county government] are working through this together. Why should we get into these spats? What’s professional about that?"

Moorlach still favors taking away Street’s investment authority, but he can’t find any allies on the board. The investigations perhaps will dictate the outcome of things, Moorlach said.

Moorlach acknowledges that Street has "some skills that are really incredible" but doesn’t think his old friend is "suited for public office as county treasurer."

But when I note that he didn’t even use his time Tuesday to say he still favored stripping Street of investment powers or to defend himself against Street’s published remarks, Moorlach conceded the point. He got caught up in the moment and didn’t make it an issue, he says.

Far be it from me to say Street has him on the run.

Maybe Moorlach was feeling charitable as Christmas approaches.

After all, ’tis the season to be jolly.

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