The California Wipeout

By John Greenwald

Even though Treasurer Robert Citron was the only elected Democrat in the government of affluent and archconservative Orange County, California, he seemed almost to own his job. People liked his folksy habit of sending out tax bills with slogans that rhymed ("Taxes paid on time never draw fines"). And they really liked the remarkably high returns that Citron earned on the billions of dollars of county funds that he managed -- income that paid for such things as gang-busting police drives in a time of tight budgets. It was thus not surprising that Citron easily won a seventh term this year, despite his opponent's charges that he had loaded up the treasury with risky derivatives and other highly leveraged investments that could decimate it with the swiftness of one bad bet.

But last week the 69-year-old workaholic Citron was forced to resign and instantly became perhaps the most hated man in Orange County. So enraged was one taxpayer at the mere sight of Citron's photo in a county office that he threatened to return with a gun and shoot it down. That outburst came shortly after Orange County, stunned by a $1.5 billion loss in the $20 billion investment pool that Citron managed, filed for bankruptcy protection in the largest municipal collapse in U.S. history. "This is the Hindenburg," said Joe Mysack, who follows the bond market as editor of Grant's Municipal Bond Observer. "There are no bankruptcies larger than this one." The unprecedented action:

-- Froze the funds of 185 Southern California school districts, towns and local agencies, casting doubt on pensions and payrolls for everyone from teachers to trash haulers.

-- Horrified the holders of more than $1.5 billion of the county's municipal bonds, who may face big losses on their investments.

-- Jeopardized projects ranging from new schools and courthouses to the $60 million expansion of an Anaheim stadium to keep the Los Angeles Rams football team from leaving the area.

The bankruptcy also spread anxiety far beyond the borders of Orange County. Japanese investors sold off dollars and U.S. securities. Stock and bond prices swung down on Wall Street amid fears that other large municipalities might harbor high-risk investments. In Washington, Federal Reserve chairman Alan Greenspan told Congress that he was closely monitoring the situation in Orange County; meanwhile, the Commodity Futures Trading Commission launched a probe into some of Citron's trades in derivatives, which are volatile securities whose value is pegged to some underlying asset or market and which can magnify an investor's gains or losses.

Municipal bond holders around the country had more than the Orange County disaster to worry about. Greenspan's strong hint last week that the Federal Reserve will continue to push up interest rates heightened worries that more governments with overleveraged portfolios heavily based on interest-rate bets could be forced to default. Already this year, derivatives have produced a bitter legacy: such disparate groups as the State of Florida, the University of Minnesota and a Shoshone Indian tribe have reported financial hits from these risky securities. "I think there will be more ((crises)) coming through the pipeline," asserts Dick Larkin, who heads the public-finance division at Standard & Poor's. All this means that, for the short run at least, many local governments may have to offer higher returns to nervous investors to persuade them to keep buying bonds.

While municipal finance may seem dry and abstract to the uninitiated, the pain of bad bets can be highly tangible. Rocked by $115 million in losses on its leveraged investments in bonds and other securities, Cuyahoga County, which includes Cleveland, Ohio, said last week it was slashing 11% from all county budgets and was freezing spending for the next four years. Some of the harshest cuts will crimp children's services, as planned hirings of social workers are put on hold. "It means that if you should be making four visits to a child's home one month, you will be able to make only two," says David Reines, deputy county administrator. "These are children who have been neglected and abused."

Orange County is far wealthier than Cuyahoga, of course, and therein lies one of the ironies of the Southern California area's financial fall. With a population of nearly 2.6 million and a median household income of $47,774, Orange is the fifth largest county in the U.S. and boasted the fourth richest county government before the crisis. As famed for its political conservatism as for Disneyland and aerospace giants like McDonnell Douglas, Orange County was the birthplace of Richard Nixon and gave Ronald Reagan the largest margin of victory of any U.S. county in his presidential races. "It's incredible, really," says Mark Baldassare, a sociologist at the University of California at Irvine. "How do you explain that one of the wealthiest counties in the nation is now bankrupt?"

Orange Countians were eager to pin it all on Citron. So conservative after hours that he preferred to keep his own money in bank accounts, Citron was nonetheless known throughout California as a high-rolling wizard when it came to public money. In 1979 Citron helped change a state law to allow counties to - borrow vast amounts through arrangements called reverse repurchase agreements. Such deals permit treasurers to take out what amount to short-term loans from firms like Merrill Lynch and invest the proceeds in longer-term bonds that pay more interest. In pursuit of this strategy, Citron added a boggling $12.5 billion of borrowed bonds to the $7.7 billion of public funds that he supervised.

The plan worked splendidly as long as interest rates continued to fall; that increased the value of the bonds, which move in the opposite direction of interest rates. Throughout the 1980s the Orange County fund raked in returns of more than 9% a year, or nearly double the average earnings of other California investment pools.

But as interest rates rose this year, the value of the bonds that Citron had bought began to tumble. To make matters worse, the Orange County portfolio held $8.5 billion of derivatives, including an exotic type called inverse floaters, whose value also plunged as interest rates climbed higher. Yet Citron, whom associates describe as self-confident to the point of cockiness, stuck to his game plan, believing rates would inevitably go lower. "He had a technique that worked for 15 years, and he didn't see the cycle change," says James Moorlach, an accountant who ran against Citron this year.

The end came last Tuesday, one day after Citron resigned and CS First Boston demanded immediate repayment of a $1.2 billion loan that the treasurer had used to buy bonds. County supervisor Harriett Wieder awoke before dawn to the sound of a police officer pounding on her door and summoning her to an emergency briefing. By 11 a.m. California time, Orange County's troubles were the talk of regulators in Washington. At 5:30 p.m. the county filed for bankruptcy protection to prevent other creditors from calling their loans and selling the fund's bonds that they held as collateral.

In the frantic days that followed, Orange County authorities strove to reassure residents that life after the bankruptcy filing would go on as usual. Officials said the filing would have "no impact" on county police, fire and paramedic services and noted that a $2 billion emergency loan from Merrill Lynch would help meet payrolls. Yet despite the brave words, the county defaulted on a $110 million issue of bonds that had raised money for pensions.

The aftermath of the bankruptcy filing soon led to finger pointing. Holders of Orange County municipal bonds sued county officials as well as Merrill Lynch and Smith Barney, claiming the firms had concealed "reckless investment practices." Not to be outdone, the county sued Nomura Securities for ignoring the bankruptcy filing and selling $900 million of bonds that it held as collateral; county officials indicated that they would sue other firms that had dumped bonds as well. And the Securities and Exchange Commission widened its investigation of the financial collapse by subpoenaing Merrill Lynch to testify.

Cities and school districts in the county found themselves scrambling for cover or quickly pulling back on their ambitions. The Laguna Beach district said it may consider its own bankruptcy filing. The city of Santa Ana said it may have to halt construction projects, including a new $100 million city jail and police headquarters.

As for Citron, he remained at home and out of sight after surrendering his $100,000-a-year job and declaring that "what I did was not irresponsible in any manner, shape or form." When Citron's investment strategy came under attack earlier this year, Bert Scott, who heads the Orange County General Services Agency, said, "It's like he walked down the street, and someone just stepped in front of him and punched him in the stomach. This has taken him totally by surprise." Even more surprising, perhaps, has been the revelation that this shy, bespectacled public servant had this kind of fiduciary power and that, with it, he turned rock-ribbed Orange County into his own casino.

With reporting by Bernard Baumohl/New York, Patrick E. Cole/Santa Ana and Bill Walsh/Columbus