25th Anniversary Look Back
Interest rates enjoy cycles, just like the stock market. Let me provide an overview of the last four decades, focusing up to the Thanksgiving season of 1994.
In 1980, the Federal Funds Rate was as high as 20%. By the end of 1991, it dropped to 4%. During 1992, with 3 easings, the rate dropped again to 3%. The Federal Reserve Board did nothing during the entire year of 1993, but 1994 was different.
In 1994, the Fed raised interest rates 25 basis points (bps) on February 4th, and another 25 bps on March 25th and April 18th. On May 17th, two weeks before the June election, they raised rates by 50 bps, up to 4.25%.
In the summer, the Fed raised interest rates by another 50 bps on August 16th. On November 15th of 1994, the Federal Reserve Board continued to tighten interest rates and raised them by 75 basis points (three-quarters of 1 percent) to 5.5%. Such a move is very rare, especially in today’s nearly flat interest rate environment. This activity can be seen on the front end of the generic chart below.
The short end of the yield curve set Citron’s borrowing costs (5.5%). But, he had invested the proceeds in 4-year bonds that were paying less than that. The Orange County Investment Pool (OCIP) had become an alligator and was now paying out more than it was earning. The longer-term bonds had also declined in value, along with the inverse floater derivatives. Being down 7% on a $21 billion portfolio meant a $1.5 billion decline in value.
With the “trend being your friend,” rates were more likely to rise than to peak or level out, let alone decline, in the very near future. On February 1st of 1995, rates did go up another 50 bps.
Mr. Citron and Mr. Raabe started communicating with the participants. The private meetings were the scuttlebutt of the municipal world.
On December 1, 1994, the Orange County Treasurer-Tax Collector issued the press release provided below. It would change my life. In fact, for the two-plus weeks following, I was constantly on the telephone responding to media calls. Occasionally, a friend would call, “I’m in Jakarta, Indonesia, and you’re on CNN. What’s going on at home?”
The press release shared information that, in retrospect, is an example of how greed does blind people. Bragging about high yields? Why don’t you just telegraph that you’re operating outside of the customary boundaries. Stating that you’ve acted “immediately”? You can’t be serious.
With the Orange County Transportation Authority already signalling they were focused on obtaining higher yields and not necessarily on loyalty to a fund manager, one can hear in between the lines that withdrawal requests were already occurring. And they were. Irvine Ranch Water District was already withdrawing $50 million a week, obtaining $100 million before Bob Citron stopped the payments (see MOORLACH UPDATE — School District Debt — August 22, 2013, MOORLACH UPDATE — OC Register — August 22, 2010, MOORLACH UPDATE — LOOK BACKS — January 23, 2010, MOORLACH UPDATE — Pension Crisis — December 20, 2009, MOORLACH UPDATE — LOOK BACKS — December 19, 2009, and MOORLACH UPDATES — OC Register — December 3, 2009). And, at my insistence, the city of Costa Mesa withdrew all of its funds that were on deposit. The dike now had more than leaks. It was hemorrhaging.
David Evans of Bloomberg News heard something was brewing in Orange County (see MOORLACH UPDATE — Memories — May 27, 2013). He posted a piece just before the County released its announcement, “Orange County, Calif., Plans Release Amid Concern About Losses.” Here are the opening paragraphs:
Orange County, Calif., is expected to make an announcement today on the status of its investment portfolio amid concern that the county faces a cash crunch caused by losses on derivatives.
The county plans to release a statement on its investments by 6 p.m. EST, said a spokeswoman for Assistant Treasurer Matthew Raabe. “We have plenty of money to pay our bills and employees,” said the spokeswoman.
Orange County Treasurer Robert L. Citron wasn’t immediately available for comment. The county treasurer is known for his aggressive investments, including purchases of derivative securities, whose value is derived from an underlying index or asset, such as bonds, currencies or commodities.
By using leverage, or borrowing money to buy more securities that he otherwise could, Citron expanded $7.3 billion in investments into $21.7 billion as of March 31.
A leveraged investor is more vulnerable to losses than gains. Many of the types of investments Orange County has, such as so-called structured notes and certain mortgage securities, lost money this year. Rising interest rates made these securities more difficult to value and sell, traders said.
A few hours later, Orange County issued this press release:
SANTA ANA, CA (December 1, 1994) — Robert Citron, County of Orange Treasurer/Tax Collector, announced today that repeated hikes in interest rates have caused a decline in the market value of the county’s investment fund. The fund manages the operating and reserve monies of approximately 180 public agencies, including the County of Orange, the County Transportation Authority, sanitation districts, school districts and cities.
According to Citron, “Across the country, bond funds have been significantly impacted by rapidly rising interest rates, especially the latest Federal Reserve Board action in November. This development has caused a decline in the market value of all bond and other funds, including the Orange County investment fund.”
The preliminary estimate of the paper loss in the Orange County investment fund is seven percent. By comparison, the largest private bond funds have experienced approximately 10 percent market value losses.
Ernie Schneider, Orange County Administrative Officer said, “The County has acted immediately to assemble a management team of county executives including Bob Citron, who, with the advice of a nationally-recognized business and securities consulting firm – Capital Market Risk Advisors, are developing a strategy for repositioning the fund’s investments.” Recommendations are expected by December 15.
The Orange County investment fund, under the guidance of Treasurer-Tax Collector Robert Citron, has consistently returned to its investors some of the highest yields in the State of California, exceeding the state’s own returns by an average of more than 3 percent annually.
Over the past 15 years, returns on the fund have averaged 10.10 percent; in the past five years, the fund has experienced returns of 8.60 percent. In January 1994, the fund had a total market value of $20 billion. The preliminary estimate of the current value today is $18.5 billion.
According to Citron, “In my 21 years of managing this fund, I have dealt with bear markets and bull markets, and am confident that we can deal with this situation.” He said, “I have devoted my professional life to achieving investment returns to benefit the citizens of Orange County. Over the years, I have worked closely with the fund participants and look forward to their continued support.”
As of today, a number of voluntary investment fund members have said that they will remain in the fund. They include OCTA, which is the largest participant in the fund.
Citron believes that, with the cooperation of all fund participants and others in the restructuring plan, the fund will not have to sell any securities prematurely at a loss. The executive management team plans to meet regularly with participants to advise them of ongoing market developments on the fund.
Bloomberg News, a wire service, would then issue the following piece, titled, “Orange County, Calif., Investments Lose $1.4 Bln,” and David Evans would be following the story in the days, weeks and months to follow.
Orange County, Calif., said its investments tumbled about $1.4 billion this year, partly because of holdings of risky securities known as derivatives.
The wealthy Southern California county’s setback would be the biggest disclosed by any municipality in the country this year. Since 1992, more than 24 cities, counties and school districts have lost hundreds of millions of dollars from investments in derivatives, whose value is derived from an underlying index or asset, such as bonds, currencies or commodities.
Orange County said the value of its investment fund, which includes money from more than 100 other California municipalities, dropped to an estimated $18.6 billion from $20 billion since January.
The county said it assembled a team of county executives and business and securities consultants to “develop a strategy for repositioning the fund’s investments.”
“Management believes that, with the cooperation of all its participants and others in its restructuring plan, the fund will not have to sell any securities prematurely at a loss,” said County Administrative Office Ernie Schneider.
Merrill Lynch & Co. shares fell as much as 1 5/8 to 36 3/8 on concern about the brokerage’s exposure to potential Orange County losses. In afternoon trading, Merrill shares were down 1 1/8 at 36 7/8.
A Merrill Lynch spokeswoman said the securities firm hasn’t lost any money because of Orange County’s investment losses.
Critics of Strategy
Orange County’s losses were predicted by John Moorlach, a certified public accountant in Costa Mesa, Calif., who lost a bid to unseat County Treasurer Robert Citron in June.
Moorlach estimated Orange County’s portfolio was down $1.2 billion in May. “This will probably be the biggest financial fiasco in the nation. We’re not talking Cuyahoga County (Ohio), $114 million. We’re talking billions.”
Citron wasn’t immediately available for comment. The county treasurer is known for his aggressive investments, including purchases of derivatives.
By using leverage, or borrowing money to buy more securities than he otherwise could, Citron expanded $7.3 billion in investments into $21.7 billion as of March 31. The county said most of its money was invested in government securities, which plunged in value as the Federal Reserve raised interest rates six times this year.
Leveraged investors reap larger losses when markets move against them and larger returns when markets move their way. Many of the types of investments Orange County has, such as so-called structured notes and certain mortgage securities, lost money this year. Rising interest rates made these securities more difficult to value and sell, traders said.
A person in the treasurer’s office who requested anonymity said the difficulties stem from investments in structured notes. In the spring, some of the country’s largest securities firms subjected Orange County to margin calls on the securities, and since then some of the securities have been returned, the person said. There haven’t been any recent martin calls.
Bonds for Sale
Analysts from Moody’s Investors Service Inc. and Standard & Poor’s Corp., Wall Street credit rating companies, plan to meet with county officials next week. “When something is going on, it is important to sit down” and discuss the situation with county officials, said Karen Krop, Moody’s vice president.
It is “not an emergency meeting,” she said. The county’s “AA1” bond rating isn’t currently under review, Krop said. “The thing will be how much liquidity the county needs” to meet its obligations, Krop said.
Robert Rifkin, an analyst at Standard & Poor’s Corp., said the company would review Orange County’s portfolio. The company decided to set the meeting after it “came away with a reason” to take a closer look at the financials after a periodic review last week, he said.
Investors are concerned about their holdings of Orange County municipal bonds, traders said. Some county notes were offered for sale and “no one picked them up,” said Robert Gore, a partner at Crowell, Weedon & Co. in Los Angeles.
Concern About Bonds
Some investors had sold Orange County bonds over the last few days, and “now people are reluctant to bid,” Gore said. Yesterday, Orange County 6% bonds due in 2009 traded at yields between 6.75% and 6.80%.
“There were about $9 million in Orange County Water District bonds out for the bid, but I heard they had a hard time getting a bid,” said Peter Barbera, a principal at Alex. Brown & Sons Inc.
Traders speculated that Orange County may lose money on structured notes. The county hasn’t tried to sell its structured note investments today, said Ted Dumbauld, a managing director at Blackhawk L.P., a New York hedge fund. Dumbauld said he hasn’t seen any large amounts of structured notes being offered today.
“I’ve not seen a single bond come into the bid,” Dumbauld said. “Normally (the county has) got big block sizes.”
Orange County isn’t the first California municipality to gain attention for using public money to make bets on risky investments.
Ten years ago a grand jury criticized officials in San Jose for “incompetence, negligence and stupidity” after the city lost $60 million in bond market bets gone bad.
The report didn’t charge the officials with criminal activity. But one member of the San Jose City Council said three city financial officers were “shooting dice with public money” for the losses, incurred selling and hedging government securities.
Of course, the newspapers would publish the news nationally in their December 2nd editions (see MOORLACH UPDATES — LOOK BACKS — December 2, 2009).
For the previous Look Back, go to MOORLACH UPDATE — PSPS Opening Remarks — November 30.
Annual Christmas Open House at Second Harvest
Please accept my invitation to come to my annual Holiday Open House on December 6th, 4 p.m. to 6 p.m., at Second Harvest Food Bank at the Great Park in Irvine. We found that this annual event has outgrown the space available in my District Office and you’ll enjoy becoming acquainted with this worthy nonprofit organization. It’s centrally located at The Great Park, 8014 Marine Way, in Irvine. The invitation is below.
This e-mail has been sent by California State Senator John M. W. Moorlach, 37th District. If you no longer wish to subscribe, just let me know by responding with a request to do so.