A:

In 1994, Orange County announced that its investment pool had lost $1.6 billion. The announcement from the Southern California county seemed as unthinkable as local authorities announcing they had discovered a glacier. Not only was this the largest loss by a local government investment pool, which forced the county to file for bankruptcy, it shattered the pristine image of municipal bonds. The strange story of how the impossible became possible starts and ends with one man - Robert Citron.

As treasurer of Orange County, Robert Citron was considered to be somewhat of an investing whiz. He consistently beat neighboring investment pools by at least 2% and, as a result, a steady flow of cash came his way. Unfortunately, of the schools, cities and districts that rushed to invest with him, very few looked into how Citron was able to produce such amazing returns. In the simplest terms, Citron counted on interest rates remaining low. From this view, the difference in yield on a short-term yield and a long-term yield offered an opportunity for arbitrage, so Citron used structured notes to take advantage of this. Although this increased the risk as well as the potential profit, it was a viable strategy. However, Citron leveraged the entire portfolio to further magnify the gains. And, therein, lied the problem.

Citron did a series of reverse repurchase agreements that allowed him to use his securities as collateral for loans to buy yet more securities. Through this method, he turned the sizable $7 billion portfolio into a $20 billion dollar position. The massive leveraging amplified his gains while interest rates followed his predicted course. In February 1994, however, the Feds began to raise interest rates and Citron's amplified gains turned into amplified losses. As the rate hikes continued, the losses became too much to control. The county was forced into bankruptcy and came up with a recovery plan to float $800 million in bonds. The bankruptcy tarnished the county's image and the municipal bonds were sold at a discount to the treasury. Luckily, the issue proved to be sufficient to protect the investors, schools among them, from insolvency. Citron, however, never served prison time for his actions.

This question was answered by Andrew Beattie.

RELATED FAQS

  1. How do I avoid a tax lien on my property?

    Find out the best way to prevent the government from placing a lien on your property, including the consequences of having ...
  2. What is the best way to start to rebuild your credit after a bankruptcy?

    Find out some simple steps you can take to rebuild your credit score gradually after filing a bankruptcy, starting with a ...
  3. What are the differences between Chapter 7 and Chapter 13 bankruptcy?

    Read about some of the primary differences between a Chapter 7 and Chapter 13 bankruptcy, including who may be ineligible ...
  4. What are the financial consequences of filing for bankruptcy?

    Learn about the various consequences, both positive and negative, that you can expect to result from your filing for bankruptcy.
RELATED TERMS
  1. Accelerated Resolution Program (ARP)

    A program designed to reduce the time and cost of resolving failed ...
  2. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
  3. Keep And Pay

    A bankruptcy allowance that lets an individual keep an asset ...
  4. 341 Meeting

    The meeting of creditors that occurs when an individual files ...
  5. Estimated Recovery Value (ERV)

    The projected value of an asset that can be recovered in the ...
  6. Recovery Rate

    The extent to which principal and accrued interest on a debt ...

You May Also Like

Related Articles
  1. Investing Basics

    These Four Industries Must Change to ...

  2. Economics

    Oil Companies Near Bankruptcy

  3. Fundamental Analysis

    Companies That Went Bankrupt From Innovation ...

  4. Personal Finance

    7 Bankrupt Companies That Came Back

  5. Stock Analysis

    Will American Airlines Fall Back To ...

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!