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.

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