MOORLACH UPDATE — The Tarnished State — December 17, 2018

The Full Measure TV news show, hosted by Sharyl Attkisson, provides a take from someone on the east coast of California in “The Tarnished State” at It is the first piece below. Orange County’s bankruptcy is invoked.

In December of 2014, twenty years after the December 6, 1994 Chapter 9 bankruptcy filing by the County of Orange, the second piece below appeared in Institutional Investor. Institutional Investor Network is behind a paywall. I issued an UPDATE on December 20, but for some unknown reason it did not get posted to my blog. Consequently, I’m providing it now as an opening LOOK BACK edition for a series on the events leading up to the infamous event, which will commemorate its 25th anniversary next December.

Like many movies, I’ll start with the conclusion first and then work my way from the beginning up to the big event.

Twenty-five years ago this month, I assembled about 60 friends, clients, and politically involved individuals in Rich and Pam Boyer’s living room, literally a short walk from my District Office. Richard G. Boyer, C.P.A., hired me in 1976, as I was concluding at CSULB. He would merge with the second oldest firm in Long Beach, Balser, Horowitz, Frank & Wakeling, and I would be admitted as a partner in 1984.

The discussion that evening was animated. I provided a business plan for the possibility of running for Orange County Treasurer-Tax Collector in the upcoming June, 1994 Primary Election. Overall, the sense was to move forward, and the rest, as they would say, is history.

The piece below provides an excellent review, in a very concise fashion, with wisdom that we still need to implement today.

If you want to know why I’ve given you the Unrestricted Net Positions of all 50 states, 58 California counties, 58 county departments of education, 72 California community college districts, 482 California cities, and 944 California school districts, the answer is simple. Allow me to quote from the piece:

Timely accurate information – Everyone along the chain of command should err on the side of unbridled curiosity, so as to strive to understand, and keep in check, unknown or inadvertent sources of risk.

The key lesson is the use of leverage. Leverage is debt. And, too many of our municipalities, from states to school districts are mired in it. This is a source of risk that will impact you, no matter where you live in California.

Let me give you an example. Last week, Sacramento City Unified School District publicly announced it will run out of cash in November of 2019. I informed you. This district ranked number 867 out of 944 (see MOORLACH UPDATE — California School District Rankings, Group 13 — August 28, 2018). This district received a disturbing audit report from the Fiscal Crisis and Management Assistance Team warning that, “without action, state intervention is certain.”

Some acronyms are used in the piece. Here is a glossary:

GSE = Government-Sponsored Enterprise, include Federal National Mortgage Association (Fannie Mae) and Government National Mortgage Association (Ginnie Mae) which were introduced to improve the flow of credit in the housing economy, while also reducing the cost of that credit.

CDO = Collateralized Debt Obligation

GASB Statement 31, which implemented fair value standards for investments, is a promulgation I’ve taken ownership of, see MOORLACH UPDATE — We’re Out! Sort Of — July 2, 2017. Here is the pertinent quote from an April, 1994 piece in The Wall Street Journal:

Mr. Moorlach says he isn’t impressed by Mr. Citron’s comment. “Mutual funds and everyone else marks to market, and if I’m county treasurer, I will mark investments to market,” Mr. Moorlach says. Not marking to market is just a way of concealing losses, he charges.

The Tarnished State | Full Measure

California has a new governor and he faces a host of challenges. The California Dream has fallen out of reach for many with the high cost of housing, health care and energy and problems with water, schools, and illegal immigration. Because of its size, what happens in California tends to have impact beyond state borders. In 2017, California’s economy was fifth largest in the world, right behind Germany—beating out Great Britain. Today, we investigate how the Golden State has become the Tarnished State.. and is on a mission to regain its shine.

Sharyl: California is known for Sun Fun and Lifestyle. It’s home to some of the world’s great innovators. But now more than ever, California is a state of wild contrasts. In the shadow of lavish neighborhoods with multimillion dollar homes are sprawling encampments filled with workers and families living out of campers and cars.

Sharyl: We’re in the heart of Silicon Valley. Google headquarters is just a couple of miles away. And this is one impact of the fact that so many workers in the state can’t afford to buy a house or even rent an apartment.

Sharyl: California’s homeless population spiked nearly 14% in 2017 — reaching 134,000.

Sharyl: What do you think is the number one challenge?

John Cox: making sure that the forgotten California the middle class can actually make a life in this state.

Sharyl: Attorney and businessman John Cox, a Republican, lost the Governor’s race to Democrat Gavin Newsom— who declined our request for an interview about California’s future. Cox campaigned against the 40% gas tax hike under Governor Jerry Brown— who also declined our interview request. California’s state tax on a gallon of gas is now 55.5 cents.

John Cox: It’s the cost of gasoline. It’s the cost of housing. It’s being driven up by regulations, by impact fees, by litigation, by delay.

Sharyl: The Golden State has racked up a growing list of troubles.

It’s home to nearly one-third of the nation’s welfare recipients, more than 2 million illegal immigrants, and one in four of America’s homeless. California residents pay among the highest taxes, but one in five lives in poverty. Its public schools rank in the bottom ten.

And it’s almost dead last when it comes to affordable housing. This modest two-bedroom house in Palo Alto was on the market for nearly 3 million dollars during our visit.

Cox: Half of the people in this state are either planning the move or are contemplating a move out of state

Grimes: Most people in the rest of the country have heard that we are the Golden State.

Sharyl: Katy Grimes is an investigative journalist who covers California politics.

Grimes: And I think it really was at one time the land of opportunity and the land of innovation. And today we are a state that is so highly regulated. We’re losing businesses, we’re losing residents, we’re highly taxed. It’s changing before our very eyes.

Sharyl: Grimes says one of California’s most looming problems is future payments owed that it cannot make.

Grimes: We now have the largest state budget in history, $200,000,000,000 but we also have a trillion dollars of unfunded pension and healthcare liability that is not being addressed.

Sharyl: What does that mean? I mean, people hear about unfunded liabilities, in simple terms what does that mean if you have a trillion dollars in liabilities?

Grimes: It means we’ve got a very, very large government workforce that were promised these extremely generous pensions. What that means is we’ve got all these future retirees that California has not figured out how they’re going to pay.

Sharyl: For all the pessimism, we found a mix of concern and optimism among Californians we spoke to.

Sharyl: What’s your view of sort of the economy of California and how livable it is?

Diana: I think it’s really hard. I think you need to have two parents working and it’s very expensive compared to other states that we’ve lived.

Matthew Borlcky: I mean it’s, it’s hard to get even apartments houses right now, but just, I think living in general California, it’s nice, but you need to have a household with multiple incomes.

Jonny Hayworth: Definitely some businesses moving out of California just because of the livability problems. But I definitely think that California is still a growing economy and you know, you won’t find any shortage of industrious kind of entrepreneurial people.

Sharyl: Is it accurate in your view to say that the criticisms of California and where it’s future is going are exaggerated or overblown?

Jonathan Lansner: Definitely.

Sharyl: Jonathan Lansner is a business columnist at the Orange County Register newspaper.

Sharyl: The conservatives seemed to be more concerned and worried and negative, and liberals seem to be less concerned and more positive?

Lansner: Let’s just say fiscal critics that tend to fall on the conservative side of the question. They are particularly concerned that state government is too big, too unwieldy and has some hidden costs that are going to come back to haunt all people of California in the coming years. I think on the liberal side, there are people who would probably argue that we’re not spending enough or spending it in the right ways. No place is perfect. This place has as many warts as, as any other, particularly with the size.

Sharyl: As a business reporter, Lansner views California’s economy as nothing short of amazing. When Governor Brown was elected in 2010, the housing industry had tanked. California was spending $27-billion dollars more than it had in income from taxes. Today, the state is running a $6-billion surplus— not counting that pesky pension liability. Unemployment is low and millions of jobs have been created.

Lansner: The recovery in the California economy, which certainly filters down to many, not all neighborhoods, is somewhat truly miraculous when you consider what people were saying a decade ago. And I think when you go back to politics, those who promised us that if we did not change the way the state acted, we were going to have financial ruin; it’s a little bit of that “Chicken Little” right now.

Sharyl: Then again— they called John Moorlach “Chicken Little” back in 1994.

Sharyl: You predicted that Orange County bankruptcy

John Moorlach: Pretty much.

Sharyl: But people scoffed at you at the time

Moorlach: Thought I was a gadfly.

Sharyl: At the time, Moorlach was running for Treasurer of Orange County, California. A certified public accountant and financial planner. He warned that their borrowing and spending was putting them on the road to ruin.

Sharyl: And at the time did people call you chicken little?

Moorlach: Yeah, Even in the newspapers. So “Sky Did Not Fall” is what the headline said. So they were inferring that I was Chicken Little. ‘Everything is fine’.

Sharyl: Everything wasn’t fine. Moorlach was right. Within weeks of his prediction, Orange County declared bankruptcy.

CBS News: The largest municipality in U.S. history to file for bankruptcy.

Sharyl: And then when it happened, Orange County actually brought you in and made you treasurer?

Moorlach: That’s right. Then I helped with the administration to get out of chapter nine bankruptcy protection. Took us about 18 months and we had to, you know, start fresh as a county that had lost a 1.7 billion. It was the largest bankruptcy in us history at the time.

Sharyl: Today, Moorlach is a California state senator whose license tag famously reads: “Sky Fell.” And now he sees another recession on the horizon.

Sharyl: What is your prediction for the near-term future of California?

Moorlach: It’s bumpy. We can talk about how wonderful things are and they are, you know, on the outside. But underneath, the house is being held together by termites holding hands together and it’s just gonna be real awful because when it, when the ship hits the sand, it’s not going to be pretty

Sharyl: If there’s something most everyone seems to agree on it has to be California’s best and most enduring feature.

Lansner: Well, it’s always embarrassing to say, but the first thing is the weather and most of the states.

Sharyl: It’s not embarrassing— it’s beautiful

Lansner: But it sounds embarrassing because it’s not sort of very, you know, cerebral, right? We want to talk about all those great things. But the weather drives a of things.

Moorlach: This is an amazing place California is its coastline, Yosemite, the redwoods in the north, that deserts. This place is amazing.

Sharyl: In the end for a lot of people life in California is a conscious trade off.

Angelica Lego: Well, you have to pay for living in a sunshine state. There is certain benefits to living here in California that you don’t find anywhere else in the country and to reap those benefits, there’s a price associated with it..

In 2017, Orange County, California finally paid off the last of its bankruptcy debt from 1994.

Revisiting a Derivatives Debacle 20 Years Later – What Have We Learned?

Note: Special IIN contributor Kristina Zucchi reported and wrote this article.

On December 6, 1994, Orange County filed bankruptcy. The world soon learned that a mild-mannered treasurer, the late Robert Citron, had blown a $1.7 billion hole in the county’s $7.6 billion general Investment Pool via a highly levered wrong-way bet on interest rates. To this day, in many corners of the institutional world, derivatives is a dirty word. And while this story has several captivating layers and mystifying subplots, it is, ultimately, a tragedy, if for no other reason than it never should have happened. Even sadder: since the episode became known, at least every few years, someone else has stood on the shoulders of failed genius and stumbled into the same sort of disaster. Galling, havoc-producing failures of oversight keep coming to light.

So what were the most important lessons of the Orange County debacle – and has the financial industry learned them? In preparing a special IIN report, we’ve spoken to some of the individuals involved, including former Merrill Lynch salesman Michael Stamenson.

The Root Causes: Inappropriate oversight; an inadequate supporting cast and substandard, informal processes all contributed to a fiduciary failure for the ages.

The Aftermath: Derivatives concocted for the sake of hedging – and risk taking – proliferated and continue to be controversial. Subprime-laced securitizations and synthetic vehicles facilitating titanic bets against them were at the heart of the global financial crisis. But the industry presses on and for every skeptical institutional investor there are plenty of others who are more than comfortable using derivatives in a variety of ways. To read a recent IIN case study about an Ontario pension plan that extracts all of its equity exposure via derivatives, click HERE.<>

Community Take: Reexamining the story of Orange County is worthwhile, says an IIN founding member. But it’s the L word, not the D word, we most need to contemplate. “What’s still most relevant today,” the member says, “is the inability to adequately comprehend and quantify leverage. Leverage takes many forms and is not always/usually/ever properly assessed. Even when recognized, it can be hard to assess the downside risk.” Adds another asset owner, “it’s timely to reinforce the Enterprise Risk Management and Governance perspectives.”

Failure #1: Inappropriate Oversight

Running the pool as elected treasurer, Citron, throughout the early 1990s, acted on his firmly held view that interest rates were heading down. He put his view to work via structured notes created by investment bankers at Merrill Lynch and other firms working with GSE issuers. Citron’s call proved prescient and his moves helped the Investment Pool notch above-market returns. County leaders, enthralled by the strong performance, gave the pool more and more money. Its assets grew from $3 billion in 1991 to more than $7 billion in 1994.

Citron had been in office for more than two decades. His investment style had been honed over many years investing in straightforward government and corporate agencies with some leverage via reverse repurchase agreements (securities allowed by way of a state law Citron helped draft in 1979). During the final few years of his tenure, he began using custom-built derivative securities, such as inverse floaters, notes that derived value from the direction of interest rates and which were structured by issuers specifically to meet his objective.

Citron, recalls Stamenson, generally used plain vanilla, not-at-all controversial derivatives i.e. government agency issues with 3-5 year maturities and fixed interest rates for 90 days that then floated to a LIBOR spread. “It was nothing the banks weren’t all doing at that time,” Stamenson says.

Citron’s overseers, the County Supervisors, were, by all accounts, ill prepared to understand the strategy and not well-educated about investments in general. According to Stamenson, Citron was not a “people person.” He was smart, intense and self-assured but he spoke with a stutter that seemed to unnerve not only himself but also the Supervisors whenever face-to-face meetings were held. But, says Stamenson, now 74, Citron was willing to discuss the portfolio with anyone who had a legitimate question. No one asked. Call it a lack of knowledge – or blissful ignorance. Consistent outsized returns proved seductive. The now infamous quote from Thomas F. Riley, former Chairman of the Board of Supervisors, sums it up: “I don’t know how the hell he does it, but he makes us all look good.”

Even when questions arose about the strategy – John Moorlach, Republican challenger for County Treasurer, gave strong vocal warnings of impending disaster during his failed campaign, as did others (who did not have a perceived political axe) – but the Supervisors failed to heed them. Moorlach: “Interest alone was projected to be 35% of revenues … THAT should have been a red flag!”

What should have been a red light instead became a green light, explains Moorlach. And it wasn’t just the OC Supervisors. The OC Budget Director and counsel and auditors all failed to notice the oversized, and vulnerably built wagon to which the pool was hitched.

Citron did try to lower the profile of his elevated returns by skimming interest earnings from one County account to another (actions for which he was later indicted) but beyond that he did not try to overtly hide his strategy. Citron continued to believe in, and bet on, his convictions. But he compounded matters by issuing pension obligation bonds to put more money into the floundering pool. By this time, his annual verbal “testimony” to the Board had given way to written reports (presumably when his stutter became too much to bear). These reports, however, provided all the details of his strategy. Some Board members were made to feel insecure by others about not understanding the complexity.

Between February 1994, when the Fed first began to tighten, and early December, the six-month Libor went from 3.6% to 6.8%. Losses mounted. Wall Street demanded more collateral. Citron didn’t have it. The market smelled blood and turned against him. The portfolio had to be triaged and liquidated. In all, some $1.7 billion was lost. The County filed for bankruptcy.

Lesson: All levels of an investment organization, from the investment managers to the risk personnel, should crave the most timely, accurate information available, at all times. Everyone along the chain of command should err on the side of unbridled curiosity, so as to strive to understand, and keep in check, unknown or inadvertent sources of risk. Proper training and education for all fiduciaries should be a top priority. Ample doses of common sense skepticism should be welcomed.

Failure #2: Inadequate Risk Guidelines and Systems

According to a former Wall Street trader who reviewed the portfolio at the time it was going up in flames, Citron had amassed upwards of 7x leverage, not taking into account the internal leverage inherent in inverse floaters.

“It was a breathtaking amount of leverage,” says Tanya Beder, a derivatives expert and CEO of SBCC Group, a risk advisory firm. “It was akin to an unregulated hedge fund. But this was gambling with the money from taxpayers.”

Citron appeared to work within the somewhat opaque guidelines set forth in California laws (Section 53601 governing allowable investment securities). These were laws Citron knew well. He helped create some of them. There was never any evidence that Citron failed to follow them to the letter. But the laws, as written, were antiquated because they failed to encapsulate the newer, more “exotic” securities such as inverse floaters. Although these inverse floaters on paper appeared to stay within the guidelines, in reality they had imbedded characteristics creating much higher risk, characteristics such as longer duration exposure. According to Moorlach, Citron’s actual duration was closer to four years. The unintended duration exposures created by using inverse floaters may not have been known, even by Citron — because the systems used by its custodian were not equipped to handle these types of securities (marking them at par rather than at market), resulting in incorrect valuations. In conjunction with inadequate internal systems, subpar custodial systems allowed this portfolio to spin out of control unchecked. And despite the higher duration, “it was the leverage [that] imploded the portfolio, not the derivatives,” recalls Moorlach.

Lesson: Investment policy statements and risk guidelines need to be written and revisited regularly to ensure they are capturing the current environment and not in and of themselves causing unintended consequences. It is incumbent for all asset stewards to be in lockstep with regard to agreed appropriate risk controls. Risk guidelines need to be thought through so they are effective and up to date for all types of securities, including financial engineered services like inverse floaters or CDOs that may slip through a crack in codified guidelines. Systems, both internal and external, are the lifeblood of risk control. Without appropriate, relevant, accurate, comprehensible information, asset stewards, whether investment trustees or staff, are ill-equipped to fully evaluate portfolios.

Failure #3: Lack of Support, Planning

Lost in the recriminations following the bankruptcy were multiple attempts by Merrill Lynch to rescue this failing portfolio during the months prior to the bankruptcy filing. All of these overtures, says Stamenson, were rebuffed by Citron who had a deep mistrust of Wall Street. It’s an ironic twist in a narrative generally presented as a simple layman being led down a perilous path by greedy bankers.

Citron’s belief that Merrill was looking to get one over on him, together with his conviction that interest rates would come down again in the near term, led him to reject repeated offers to unwind when there was still a chance to minimize damage. Citron was operating with one assistant, but as Treasurer he was, essentially, a solo act. In a team environment — say, at a hedge fund — he may have been challenged, industry members say.

By the time margin calls came, the Supervisors were blindsided by the magnitude of the problem. The County was in turmoil and further handicapped by a law requiring notice (of up to 24 hours) prior to the holding of special meetings. It was a delay which was akin to a lifetime in the derivatives market. By that time, the County had nowhere to turn. Some of the people that might have been in a position to help clean up the mess were paralyzed by potential conflicts. A local judge might have issued a temporary order buying the County some time, but tricky ramifications held them back; an outside advisor, LeBoeuf Lamb, resigned over conflicts resulting from their involvement in some controversial OC bond issues. Internal counsel was unwilling or unable to step in. Wall Street sent representatives to institute a bailout plan, which included an offer from Merrill Lynch to provide a $2 billion overnight repurchase agreement to provide the much needed cash. But with no leader (Citron resigned), no adequate counsel to act as fiduciary and no temporary restraining order, the County filed Chapter 9.

Lesson: No man is an island. An investment organization needs a team of impartial, well-educated contributors. Support layers, advisers, yes even consultants, are integral components to ensure that when calamity strikes, the organization will not be left scurrying in the dark. Contingency planning is paramount.

The Aftermath

The ramifications from the episode resonated with municipalities everywhere and there were lessons that were not lost or left unlearned. After all was said and done, investment policy statements were required by the California state statutes with mandatory reviews at least annually. The Government Accounting Standards Board (GASB) issued Statement 31 requiring all municipal governments report their cash portfolios at market value, a standard Moorlach joking calls the “Moorlach Standard”. Gone were the days of playing duration and focusing on yield. Immediately after the OC implosion, municipal treasurers all shorted up and according to a source at one rating agency, the average weighted maturity of muni portfolios was as low as 20 days. Investment professionals also took to heart the need to upgrade the financial talent and surrounded themselves with highly trained investment professionals, employing internal or external credit analysts.

The takeaways from this debacle are numerous. One thing remains clear: financially engineered instruments will continue to proliferate. This raises the inevitable possibility that risk metrics and systems will lag and fail to properly measure them as overseers play catch up. Restrictive regulations put in place fail to fully deter overzealous yet in many ways banal collective behavior for if the security issuers have shown anything it is that they are adept at innovating ways to circumvent restrictions through the creation of new instruments, or new nomenclature. And so it goes. Keep the old saw handy — if it looks too good to be true, it probably is.


Bob Citron died January 16, 2013. After the bankruptcy was filed he was found guilty on six felony counts. He was sentenced to work in the county jail but never spent a night behind bars. His probation ended in 2002. Citron’s assistant Matthew Raabe was similarly convicted and served over a month behind bars before his verdict was overturned. Several County Supervisors had their indictments later dismissed. It was ruled by an appeals court that “failing to do their jobs wasn’t a crime.”

John Moorlach was elected as treasurer after the resignation of Citron and served in that position till 2006. He continues to be involved in Orange County government, currently as Supervisor of the 2nd district, a post he will be retiring from at the end of 2014.

Orange County sued Merrill Lynch for $2 billion. The case was settled on June 3, 1998 with Merrill paying just over $400 million.

Michael Stamenson is retired and living in the Western U.S. He and other executives at Merrill Lynch were not personally sanctioned by the SEC for their involvement with the OC bankruptcy. The SEC concluded that the “failings with respect to Orange County were a firmwide pattern of negligence — from the trading desk and sales personnel to the investment banking side — that constituted unintentional fraud … we made a determination that this case was about a collective failure at Merrill Lynch,” former SEC Pacific Regional Director Elaine Cacheris told media outlets. The only penalty Merrill paid to the SEC was for $2 million with respect to charges that the firm mislead investors who purchased the muni bonds without disclosing the County’s financial risks. All told the County reaped almost $800 million from its suits against the investment banks.

Orange County emerged from bankruptcy 18 months after its filing. The participants in the pool recovered up to 97% of their investments by February of 2000. And repayment of the long term bonds it issued to cover short term debt are slated to be paid off in 2016. In the long run, Orange County, no longer the largest municipal bankruptcy, emerged relatively unscathed.

A California state ban on municipalities investing in inverse floaters remains to this day.


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