Don’t Blame Derivatives

This is the final in a three-part series taking a look at the lasting effects of the Orange County Chapter 9 municipal bankruptcy on Dec. 6, 1994. In this article, municipal market participants look at the role and impact of derivatives in the financial debacle.

A decade after Orange County, Calif., filed for Chapter 9 bankruptcy protection on Dec. 6, 1994, some market participants are still struggling to erase the negative connotation that became associated with the word derivatives because of the county’s investments and subsequent losses in those financial instruments.

Some derivative experts argue that the bankruptcy was caused by flawed investment policies and practices — and not because of derivatives. They note that Orange County in 1994 invested partially in inverse floaters, a risky form of derivatives that bet on the direction of interest rates to raise funds.

That stance is in direct opposition to the majority of today’s municipal users of derivatives, who utilize them primarily as risk-management tools and to manage debt service costs, and not as proprietary investments, said Lary Stromfeld, head of municipal capital markets at Cadwalader, Wickersham & Taft, in a recent interview.

The current treasurer of Orange County — which is located about 30 miles south of downtown Los Angeles and 90 miles north of San Diego — is John Moorlach. In an interview earlier this week, he agreed that derivatives did play a part in the county’s bankruptcy.

“The key problem was not with derivatives, it was leverage,” he said. “Derivatives were a problem in that [former county Treasurer Robert Citron] had more inverse floaters, than floaters. They were also very complex. They were proprietary products designed just for Orange County.”“It was like mixing sleeping pills [leverage] and a little alcohol [derivatives] and they just don’t mix,” Moorlach said. “It made a sad concoction.”

The bankruptcy and its association with derivatives came around the time corporate investors were also seeing widely publicized losses in derivatives, Moorlach recalled.

“Orange County was the exclamation mark at the time. It wasn’t the first capital letter in the sentence,” he said. “Derivatives were already getting beat up months before Orange County blew up. It just turned the letters from normal print to bold.”

Since the bankruptcy filing, sayings such as, “You don’t want this to turn into an Orange County,” were repeated in board rooms across the country by some who did not understand the difference between how the county used derivatives and how others used them to hedge risk.

Milton Wakschlag, partner at Chicago-based law firm Katten Muchin Zavis Rosenman declined to comment on the specific causes of the bankruptcy. However, he said earlier this week that a “silver lining” evolved from the Orange County situation because it forced people to look at derivatives in a more “penetrating and compelling” manner. “People who structured, bought, and used derivatives,” he said, forced themselves to be more sophisticated about the instruments.Derivatives are now viewed as “a must-read complex novel,” Wakschlag said. “You’ve got to figure out what huge benefits you’ll get from it. If you’re not careful, there’s a potential for huge costs.”

Wisconsin capital finance director Frank Hoadley said the state completed its first and only swap — a floating-to-fixed rate transaction — in connection with a $1.8 billion pension obligation bond issue in December 2003. He said the biggest advantage in utilizing the swap on $600 million in auction-rate securities was that it gave the state the ability to reshape the debt in the future.

The swap also allowed the issuer to obtain a lower interest rate than it would if it had issued fixed-rate securities, he said. Hoadley noted that the state would like to have the statutory authority to consider synthetic refunding — selling variable-rate refunding bonds and swapping them to fixed rate. Even if it had the statutory authority, however, it would not pursue such a refunding because it does not currently see “any clear advantage,” he added.

Hoadley also noted the risks associated with using derivatives. One concern includes basis risk stemming from the relationship between The Bond Market Association index and the London Interbank Offered Rate benchmark, he said.

“People are comfortable with a presumed relationship,” between the benchmarks, Hoadley said. That could change and the market could see “unpleasant consequences,” he said, if the spread between the benchmarks widen — or in some cases narrow.

“The other worry is that it is an entirely unregulated market. If you’re going to sell or underwrite municipal bonds,” Hoadley said, you’re subjected to all kinds of licensing requirements, but there are “no qualifications for swap advisers.”

“If something blows up, it will blow up in an unregulated environment,” he added.

THE FLAWED STRATEGY

The association of derivatives with Orange County was born out of former county Treasurer Robert Citron’s mismanagement of entrusted funds. He used the securities in the county’s investment pool as collateral for borrowing money that he then used to buy other securities. As interest rates rose in 1994 and the value of the underlying investments dropped, the county pool faced collateral calls.

The losses and declining returns in the fund forced the communities that had put money into the pool to make withdrawals, further reducing the pool’s flexibility in dealing with the rising-rate environment. Citron, who had been the county’s treasurer for 22 years before his resignation Dec. 4, 1994, used an investment strategy of reverse repurchase agreements and other derivatives that led to returns above 10% annually for some 15 years, until short-term interest rates started rising in February 1994, fueling about $1.6 billion in losses on the portfolio.

“The investment strategy implemented by Citron used the proceeds of short-term borrowings and other moneys to invest in longer-term securities — in many cases complex, highly volatile derivatives — and pledging these ‘investments’ in order to borrow still more money through reverse repurchase agreements to acquire additional securities, thus increasing the interest rate bet,” according to a filing with the U.S. Bankruptcy Court for the Central District of California in June 1996. The investments worked well until interest rates trended up.

In using that strategy, Citron “violated constitutional and statutory restrictions and regulations that limited his investment and borrowing authority, by illegally committing the county’s investment portfolio to a massive wager that interest rates — already at low levels by historical standards — would remain low or fall even further,” according to the filing.

The investment portfolio was not limited to the county’s money, but together with other municipal government agencies, were commonly referred to as the Orange County Investment Pools.

“The question is not if the products were ineffective,” said Robert Doty, president of Sacramento-based American Governmental Financial Services Co. “The issue is to apply means for using them responsibly.”

CONSEQUENCES

On Dec.1, 1994, Orange County announced a paper loss of $1.5 billion in its investment pool, which was later increased to $1.67 billion in real losses, according to Moorlach said. He noted that the county — after announcing Citron’s resignation and seeking protection under Chapter 9 of the bankruptcy code — opted to sue numerous participants involved in the scandal over the next few years in an effort to recoup roughly $800 million in litigation settlements.

Unlike other bankruptcy laws, Chapter 9 is specific to municipalities and allows the issuer to reorganize its debt. The law does not include a provision for liquidation of the assets of the municipality and distribution of the proceeds to creditors.

Orange County sued Merrill Lynch & Co., the firm that was the primary broker for Citron’s risky investments scheme. On June 2, 1998, Merrill announced it had agreed to pay the county $400 million to end the lawsuit against the firm. The firm also agreed to “return excess collateral of approximately $20 million that it had been holding for distribution to the pool participants,” according to a Merrill press release issued at the time.

Orange County severed ties with Merrill Lynch until eight-and-a-half years after the bankruptcy filing, when the county’s Board of Supervisors voted in June 2003 to finally renew ties with the investment bank. At that time, the county voted to allow officials to purchase investments through the firm, Merrill spokesman Bill Halldin said earlier this month. Any underwriting business will still have to be authorized by the board, he added.

Halldin said one impact stemming from the bankruptcy filing is that “we monitor our relationships with public entities even more carefully than we did in the past. It impacted our dealings with some issuers in California in the 1990’s, but it has no impact today.”

“Leverage was the primary issue in the county’s losses, not derivatives,” Halldin said. Regardless of what the issue is, he contended, Merrill Lynch did not contribute to the negativity surrounding derivatives.

In the late 1990s, the county also settled with KPMG Peat Marwick, Morgan Stanley Dean Witter, Credit Suisse First Boston Corp., Nomura Securities International Inc., LeBoeuf, Lamb, Green & McRae LLP, Brown & Wood, Rauscher Pierce Refnes Inc., Fuji Securities, and Bear, Stearns & Co.

Standard & Poor’s parent company, the McGraw-Hill Cos., was the last defendant in Orange County’s fight to recover losses. The company settled for $140,000 in June 1999. A spokesman for Standard & Poor’s said last week that the figure represented a partial refund of the county’s fees.

IMPLICATIONS

In the years following the bankruptcy filing, the market for the universe of municipal derivative risk management products was stunted, despite the obvious differences in the proprietary investments made by Orange County. The scandal had many implications for the municipal bond market.

Treasurer Moorlach said the Board of Supervisors has updated and reviewed its investment policies and guidelines since the bankruptcy filing.

He said Orange County now avoids investing in complex derivatives, such as inverse floaters. The county now invests in floaters that reset on a specific date and are based on a specific index, he added.

The biggest impact of the bankruptcy was the recognition of governmental bodies and rating agencies of the importance of oversight in management, according to Martin Stallone, managing director of the Investment Management Advisory Group Inc., a Pottstown, Pa.-based derivatives services firm.

The event created an awareness of the need for accountability and precision in analysis, Stallone said. He referred to Standard & Poor’s recently published scoring system that outlines the agency’s criteria for measuring the potential financial loss stemming from the use of over-the-counter derivatives.

“The criteria that the agency looks at includes management, policies, monitoring, and evaluating,” Stallone said. If these types of controls were in place before Orange County declared bankruptcy, he added, then perhaps the situation wouldn’t have reached the magnitude it did.

Those in California now have a careful approach to derivatives and such instruments have slowly become more acceptable, according to Stallone. “Now that derivatives are getting to a grassroots level, the potential for mishaps is greater and increases the need for competent financial advisory services,” he said.

For example, in Pennsylvania, a school district previously could not utilize derivatives, but recently there has been legislation passed that allows it. The question now, Stallone says, is do they have the sophistication to manage it?

“It’s not too distant a memory, so it keeps people grounded,” Stallone said. “Maybe that won’t be the case on the 20th anniversary.”

Stromfeld of Cadwalader Wickersham said despite the negative publicity, the Orange County scandal “had an educational effect.” The publicity generated around the losses suffered served as a catalyst, motivating people to learn how to use derivatives, he said.

According to Stromfeld, derivative instruments were tainted by association with Orange County’s losses. But because of the high profile derivatives achieved as a result of the bankruptcy, he said, the market has gradually become more familiar with the instruments and is more willing to consider them in most transactions. Most people will now consider if a derivative should be included as part of a particular deal, he said.

The Orange County saga also caused municipal issuers to examine their investment policies more carefully. “Doing derivatives is not necessarily a bad thing,” Stromfeld said, but they “need to be used properly.

“Boards and governing bodies undertook a review of their investment practices to give guidance to their officers on how to implement derivatives in an appropriate manner,” he said. The bankruptcy filing also “led to legislation in states all around the country that expressively authorized municipalities to enter into derivatives,” Stromfeld said. Before that, he added, legislative authorization was not as common and people had to rely upon “implied power.”

Legislation varies among states and allows issuers to invest in derivatives and well as to use them for other purposes — although “the vast majority of users use them for hedging or managing debt service costs,” Stromfeld said.

Doty of AGFS said that “one of the hidden dangers is that we get information from other people … the sources or suppliers of various forms of derivatives and various credit enhancers and others.”

With the Orange County case, the Securities and Exchange Commission implied that issuers “are responsible for information coming from third parties,” Doty said.

“The Orange County Board of Education, the cities of Irvine and Anaheim, along with other issuers were held responsible for information that came from Orange County,” he said. “Even though the information received from the county was inaccurate, they were held responsible for it.”

In the wake of the historic bankruptcy, the SEC indicated that “issuers have an investigatory responsibility,” Doty said — they used that information in their official statements and were responsible for it.

In light of his illegal activities, Citron pleaded guilty to six felonies during a 1995 court case and was sentenced to one year in jail. His former attorney David Wiechert of the Law Office of David W. Wiechert, said in an interview last week.

Wiechert noted that Citron completed his sentence by working for about nine months in the commissary for the Orange County jail and received credit for “other things he did for the county.” He noted he has not been in touch with Citron since the court case ended. Wiechert still practices law from his San Clemente, Calif.-based firm and works primarily on “white collar cases,” he said.