By: Ronald D. Struck                                                               December 9, 1999

Orange County Investment Pool

 The media is now asking whether the bottom could again drop out from under the Orange County Investment Pool.  The question should be - when will the public and media again become complacent about their supervision responsibilities?  Why?  Because, they don't focus on the right thing - the enormous risks associated with leverage.  Even worse, they convey "investment guru" status upon investment managers who achieve temporary success by utilizing leverage.

 

In the late 1980's and early 1990’s, Mr. Citron was the investment guru of Orange County, in the eyes of the cities, rating agencies, and for the most part the media.  Mr. Citron had had a long run at substantially beating the market; everyone who participated with his investment pool was laughing all the way to the bank, so therefore he had to be an investment guru.

 

There are NO investment gurus, especially if the primary tool they utilize is leverage.  Investment managers put their pants on just like everyone else.  So, they must do something unusual to "beat the market," and if they are substantially beating the market, they have to be doing something VERY unusual.  Mr. Citron didn't get in trouble because he invested in unusual, exotic securities, as reported by some of the media.  He got into trouble for the same reason most public funds (and many private ones as well) have gotten into trouble - leverage.

 

Yes, Mr. Citron increased his pool’s returns the old fashioned way; he leveraged $5 billion of cash into a $25 billion investment pool by borrowing at low short-term rates and investing at higher long-term rates.  As the S&L industry can attest, this strategy works only if market interest rates cooperate, as they did from the time Mr. Citron started investing in the late 80's until 1994.  But, because of several years of generating returns well above market averages, everyone had conveyed upon Mr. Citron guru status, and the public didn't think oversight or review was necessary.

I first became aware of the specifics of Mr. Mr. Citron's investment strategy in early 1994.  

In an effort to offer portfolio management services, I personally spoke with virtually every city treasurer in Orange County.  They told me that they had their money in Mr. Citron's pool, getting returns of over 8%.  At that time, the investment pool for cities administered by the State (known as LAIF) was only providing returns in the 4.5% range, returns with which my portfolio management program could easily compete.  However, my program couldn't even get close to Mr. Citron's 8% returns.  

I come from the school that strongly believes that there is “no free lunch.”  Therefore, I immediately suspected Mr. Citron had to be undertaking major risks in order to generate such high returns, and I strongly suspected it was leverage.  When I discussed my concerns with several city treasurers they did not share my concerns.  They said Mr. Citron had successfully managed the pool for years, he had told pool participants that his program efficiently managed his leverage risk exposure, and, in any case, because the pool was so big and complex, it would be a major project to evaluate what he was doing.

About the same time, Mr. John Moorlach had announced his candidacy for the treasurer's office and was voicing his concerns about the risky-ness of Mr. Citron's pool.  I contacted Mr. Moorlach, indicated I too was concerned, and volunteered to analyze the pool in detail and provide him with an evaluation if he could provide me with the pool data. 

 

Within a couple of days Mr. Moorlach provided me with a four or five-inch thick computer run itemizing Mr. Citron's $25 billion investment pool.  The position that it would be a major project to evaluate the pool proved to be incorrect.  With internet access, a yellow pad, and a calculator, I was able to quickly complete an analysis and provide Mr. Moorlach with an evaluation.  It quantified the very high risk in Mr. Citron’s pool as a result of leveraged exposure, provided specific estimates of the potential losses that would be incurred at slightly higher interest rate levels, and outlined potential corrective actions that could be taken.  

 

Unfortunately, Mr. Moorlach did not get an opportunity to take any corrective actions because the public decided to re-elect their proven investment guru, Mr. Citron.  Amazingly, soon after the election, interest rates increased and Mr. Citron's pool collapsed, precipitating the largest county bankruptcy in the history of the nation.  

 

The citizens of Orange County, and the media, said they didn't see it coming.  I guess they couldn't hear or read either.  After I provided my evaluation to Mr. Moorlach, in his campaign for treasurer he was very vocal about his concerns about the magnitude of risk in Mr. Citron's pool.  He got a lot of press coverage about his concerns but, more often than not, it was condescending in tone.  Apparently the press believed Mr. Moorlach was just using it as spin in order to get elected.   

 

However, I was not seeking election.  I am a professional portfolio manager.  I personally had follow-up telephone conversations with many city treasurers I had originally contacted and discussed my  findings.  I got two basic reactions - continuing unconcern about the risks, because Mr. Citron had assured them that he had everything under control, and, this time, anger, because I was assisting Mr. Moorlach in stirring up the pot and making it difficult for Mr. Citron to do his job. 

 

So, alas, the red flags run up by Mr. Moorlach and me had no impact.  For the most part, the city treasurers, the media, and even the rating agencies, continued to be in awe of Mr. Mr. Citron’s successes, and gave him the benefit of the doubt, until it was too late.  Then the county incurred multi-billion dollar losses.

 

Will it happen again?  Certainly, but probably not in Orange County, at least anytime soon.  Why, because the people of Orange County, and hopefully the media, place less faith in gurus now.  But, more importantly, the county now strictly limits leverage (leverage limitations should apply to all custodians of public money).

 

Unfortunately, because pool investors got burned by Mr. Citron's pool management, now there has been a major overreaction to the opposite extreme.   How do I know?  Because of the same red flag I saw about Mr. Citron's pool.  His returns were too high and now the pool's returns are unnecessarily too low.  

 

Mr. Citron was removed from office and replace by, who, Mr. Moorlach.  Mr. Moorlach did not create the Orange County Investment Pool's problems, he solved them.  Unlike Mr. Citron, who operated in a secretive manner and fought all controls, Mr. Moorlach is a prudent and efficient manager of the investment pool.  He provides supervisors and the public with detailed information about all of his investment activities, and proactively seeks participation in monitoring them. 

 

But, while the restrictions and overview applied to Mr. Citron's activities were grossly insufficient, the county has overacted and adopted overly conservative, money market type investment restrictions for Mr. Moorlach.  For example, the average maturity cannot exceed 90 days and the list of permissible securities is unnecessarily limited.  

 

Permitting Mr. Moorlach to maximize the returns on the pool with expanded but prudent investment authority should be a top priority for Orange County.  Why should the taxpayers continue to forego tens of millions of dollars in investment earnings just because Mr. Citron was not supervised properly?

Top