Moderation + Predictability = Bliss: The Cases of Orange and Jefferson Counties
Martin Ives Distinguished Adjunct Professor of Public Administration Robert F. Wagner Graduate School of Public Service New York University Former First Deputy Comptroller, New York City and Deputy Comptroller, New York State 47 Lexington Drive Croton-on-Hudson, NY 10520 email@example.com
Ryan Yeung* Ph.D. Candidate in Public Administration Graduate Research Associate Center for Policy Research Maxwell School of Citizenship and Public Affairs Syracuse University 426 Eggers Hall Syracuse, NY 13244 firstname.lastname@example.org http://student.maxwell.syr.edu/ryyeung/
Abstract We look at the role of sudden financial catastrophe brought on by a combination of (a) failure to assess the risks associated with the temptations of Wall Street’s latest financial instruments and methods; (b) failure to fully understand the implications of those financial instruments and methods; (c) failure to seek the advice of completely independent financial advisors; and (d) just plain bad luck. In support of this thesis, we offer two case studies: one old (Orange County, California) and one still unfolding (Jefferson, County, Alabama). Both catastrophes could have been avoided if municipal officials had acted in moderation and stuck to the basics instead of putting themselves in a position where bad luck helped cause their strategies to backfire.
According to Berne and Schram (1986) a government’s financial condition relates to the likelihood that it will, in the future, meet its financial obligations to suppliers, employees, creditors and bondholders as the obligations come due, as well as its obligations to provide services to its individual and corporate citizens. Thus, financial condition concerns a government’s ability to pay its bills, maintain basic services, and finance capital needs in the face of periodic economic contraction. It follows that a municipality in fiscal stress is one that is unable to: Generate sufficient cash to meet it near-term obligations (sometimes called ―cash solvency‖); Generate sufficient recurring revenues each year to meet recurring expenditures and maintain a fund balance sufficient to cushion the effects of economic contraction (sometimes called ―budgetary solvency‖); Reasonably anticipate raising sufficient future revenues to pay its longer-term obligations, such as long-term debt, pensions, and post-employment healthcare benefits (sometimes called ―long-term solvency’); and Reasonably anticipate the financial ability to provide needed basic services to the citizenry (sometimes called ―service-level solvency‖). When we consider the causes of municipal fiscal stress, we tend to emphasize the interplay of economic, demographic, and political/administrative factors. Fiscal stress is sometimes caused by the lack of fiscal discipline during periods of economic expansion and sometimes, by the lack of fiscal discipline during periods of economic contraction. Nassau County, New York encountered fiscal stress a decade ago because of political decisions to provide additional services while keeping tax rates artificially low and ―balancing‖ its budgets through fiscal gimmickry. Bahl and Duncombe (1992) suggest that the lack of long-term fiscal planning and the failure to curb expenditures caused New York State to encounter fiscal stress in the late 1980’s. To this list of causes of municipal fiscal stress, we add one more: sudden financial catastrophe brought on by a combination of (a) failure to assess the risks associated with the 1
temptations of Wall Street’s latest financial instruments and methods; (b) failure to fully understand the implications of those financial instruments and methods; (c) failure to seek the advice of completely independent financial advisors; and (d) just plain bad luck. It is important to recognize, however, that a strong internal control system, which includes effective risk management policies and practices, can minimize losses brought about by bad luck. In support of this thesis, we offer two examples: one old (involving Orange County, California) and one still unfolding (involving Jefferson, County, Alabama). Officials in these counties engaged heavily in a variety of exotic derivatives and other risky financial strategies; the major difference being that Orange County used risky financial strategies in an attempt to increase revenue, while Jefferson County used them in an attempt to control its debt service expenditures. Both catastrophes could have been avoided if the counties had stronger control systems and their officials had acted in moderation and stuck to the basics instead of putting themselves in a position where bad luck helped cause their strategies to backfire. We begin by laying out some definitions of key financial terms necessary to the understanding of the rest of this paper. Section 3 presents the issues and circumstances surrounding the Orange County bankruptcy. Section 4 presents the issues and circumstances surrounding Jefferson County’s current predicament. The final section concludes and offers lessons learned from these experiences.
Some Definitions To better understand the problems encountered by the two counties, we need to describe briefly the financial instruments they acquired. We will discuss them further in this paper, but it was the excessive use of these instruments that led to the counties’ severe financial losses.
Reverse Repurchase Agreement A reverse repurchase agreement is a type of collateralized borrowing. A municipality receives cash by transferring securities to a financial institution, promising to repay the cash plus interest at a later date. When the borrowing is repaid, the lender returns the securities to the borrower. If the security’s value declines before repayment of the borrowing, the municipality may be obligated to provide more securities or cash to the lender. Orange County made significant use of reverse repurchase agreements for the purpose of leveraging—making additional investments with its available resources.
Derivative A derivative is a financial instrument whose value is linked to (or derived from) an underlying asset, index, or market, such as stocks, interest rates, or currencies. When derivatives are used, a small movement in the ―underlying‖ can cause a large difference in the value of the derivative. Derivatives can be used to mitigate risk, but they can also be used to speculate. When used for speculative purposes, the speculator can profit if the value of the underlying moves in the direction anticipated by the speculator…or lose if the value moves in the opposite direction. A commonly used underlying index for derivatives is the London Interbank Offer Rate (LIBOR), the interest rate at which banks offer to lend unsecured funds to other banks in the London wholesale money market (Governmental Accounting Standards Board 2008). Orange County invested heavily in derivatives to increase its investment income; Jefferson County used other forms of derivatives to control interest expenditures.
Auction Rate Security
An auction rate security is a long-term debt instrument wherein the issuer pays variable interest rates, rather than a fixed interest rate. The interest rate on these securities is regularly reset at short-term intervals–typically every 7, 28, or 35 days–through a modified Dutch auction. In the typical Dutch auction, the auctioneer begins with a high asking price, which is lowered until someone accepts the seller’s minimum acceptable price. With auction rate securities, potential investors engage in a competitive bidding process through broker-dealers, specifying the amount of bonds they wish to buy at the lowest interest rate they are willing to accept. The interest rate paid by the issuer is the lowest bid rate at which all the bonds can be sold. Because of the short-term interest rate reset feature, auction rate securities have lower interest rates than fixed-rate debt. But they also carry higher risks than fixed-rate debt because future increases in interest rates may be greater than the anticipated savings from the use of auction rate securities. Further, downgrades in the future credit rating of either the issuer or the insurer of the bonds may cause the auctions to ―fail‖ and interest rates to increase. Jefferson County issued a significant amount of these securities.
Swap and Interest Rate Swap A swap is a type of derivative in which there is an agreement to exchange future cash flows. An interest rate swap is a swap that has a variable payment based on the price of an underlying interest rate or index. Interest rate swaps are used to reduce the risk of future changes in interest rates. For example, a municipality might enter into an interest rate swap to hedge against the interest rate risk related to its variable-rate (auction rate) securities. Based on the swap agreement, the municipality owes interest calculated at a fixed rate to the swap counterparty; in return, the counterparty owes the municipality interest based on a variable rate
that matches the rate on the municipality’s bonds. Only the net difference in interest payments is exchanged. The net result of the arrangement is that the municipality effectively pays a fixed interest rate on its debt. If the counterparty defaults on the arrangement, the municipality will be exposed to variable interest rates, and potentially have to put up collateral. The Bond Market Association (BMA) swap index is often used to determine the amount of cash to be exchanged in the swap. This index is a national rate based on about 250 high-grade tax exempt variable demand obligations. The index can fluctuate significantly based on market conditions (DerivActiv 2008; Provus 2001). Jefferson County made significant use of interest rate swaps.
The Orange County Bankruptcy Background Orange County is the fifth largest county in the United States, with a population of more than 3 million in 2008. It is also one of the wealthiest counties in California and in the nation. Orange County’s median household income was estimated at $73,107 for 2007, compared with $59,928 for California and $50,740 for the country as a whole. Its percentage of persons living below the poverty line in 2007 was estimated at only 8.9 percent, compared with 12.4 percent for all of California and 13.0 percent for the entire country (U.S. Census Bureau 2009). According to California law, the treasurer of Orange County ―is responsible for receiving and keeping safe all monies belonging to the county and all other moneys directed by law to be paid to the treasurer‖ (California State Auditor 1995). State law generally requires school district funds to be held by the Treasurer and, during the years preceding the bankruptcy, many cities and special districts had voluntarily deposited their funds with him.
Orange County Treasurer Robert L. Citron had been serving the citizens of Orange County for some 24 years, when the world collapsed around him on December 5, 1994. By all accounts, he had been very successful at his job. Orange County reported that the yield on its investments averaged 8.46 percent in fiscal year 1993 (Orange County Auditor-Controller 1993). Orange County’s July 1994 Official Statement noted that the County’s investment pool had earned 7.8 percent to 8.85 percent a year from 1991 through 1994. The New York Times reported that Citron became ―a local hero by earning profits in excess of 7 percent when other county funds settled for half as much‖ (Orange County's Fatal Error 1994). Several cities and school districts even issued large amounts of taxable notes for the purpose of profiting from Citron’s investments.
The Investment Strategy One might not be too concerned with the Treasurer’s investment policy if you were just to read the discussion of cash management policy in the County’s financial report. It reads, ―Cash temporarily idle during the year was invested in U. S. Government securities, certificates of deposit, demand deposits, commercial paper, repurchase agreements, reverse repurchase agreements, and medium term corporate notes. The County’s investment policy is to obtain a satisfactory yield while preserving safety and liquidity of the investment portfolio…‖ (Orange County Auditor-Controller 1993). The Treasurer’s Statement of Investment Policy states that preservation of investment capital is the primary concern; achievement of a high yield must be considered secondary to the safety and liquidity of the investment portfolio (California State Auditor 1995).
But, to quote an old maxim, ―the devil lies in the details,‖ and the Treasurer’s actual investment strategy differed considerably from the stated policy. There were three components to the investment strategy: (a) leveraging, (b) borrowing short-term and using the funds to invest for longer time periods, and (c) investing in complex financial instruments known as derivatives. This strategy was based on the assumption that interest rates would decline or at least remain stable. We leave it to the reader to judge whether this was an investment strategy or a gambling strategy.
Leveraging If you own a security and are temporarily short of cash, you might use a reverse repurchase agreement to borrow cash, using the security as collateral. When you repay the lender, you get the security back and the transaction is ended. But, when used as an investment strategy, leveraging with reverse repurchasing agreements has the effect of using the same money twice (or even more than twice), giving you the opportunity to increase significantly the return on your original investment. The strategy works wonders, provided you can continue to invest at rates greater than you can borrow. Unfortunately, the strategy also magnifies the risk of loss if the borrowing rate were to exceed the investment return rate. Citron leveraged heavily. By November 30, 1994, just before the roof fell in, the Treasurer’s investment base of $7.6 billion had been leveraged to $20.6 billion in investments– 2.7 times the investment base. One investment of $100 million was leveraged 29 times to produce investments of $2.9 billion! (California State Auditor 1995).
Borrowing Short-Term, Investing for Longer Periods
As noted, for leveraging to work, Citron had to borrow at rates lower than those at which he could invest. As a general rule, short-term interest rates are lower than long-term interest rates. Citron tended to borrow through reverse repurchase agreements for periods less than six months and then invest the proceeds for periods averaging about four years (California State Auditor 1995). Although this strategy sounds like a nice way to make profit, it creates major interest rate risks. First, the user must keep rolling over the short-term borrowings at interest rates lower than the longer-term investments, lest the borrowing costs exceed the investment returns. Second, the lender may demand more collateral if increased interest rates cause the value of collateral to fall.
Investing in Exotica Beginning in 1991, Citron substantially increased the amount invested in derivative securities. His investments in low-risk U.S. Treasury securities and repurchase agreements declined to about four percent of the investment portfolio between 1991 and November, 1994; but the proportion of risky floating interest rate notes rose from zero to 32 percent of the portfolio during the same period (California State Auditor 1995). Derivatives can be designed to suit the buyer’s needs. If the buyer thinks interest rates will fall and wants to place a bet on it, derivatives can be designed so the buyer will profit if interest rates actually fall. In anticipation of falling interest rates, Citron purchased a large amount of complex financial instruments called ―inverse floaters.‖ The interest rate on inverse floaters moves in a direction opposite from the underlying index. An inverse floater, for example, might have an interest rate of, say, 10 percent minus the six-month LIBOR. When LIBOR was at 3 percent, the County earned 7 percent, but when LIBOR went above 6 percent,
the County earned only 4 percent. In short, when interest rates decline, you win, but if they increase, you lose (California State Auditor 1995; Bary 1994). Not only can speculators lose heavily if interest rates move opposite from the direction on which they are betting; investing in these structured instruments also reduces liquidity because they may be hard to sell.
Enter Alan Greenspan and the Strategy Collapses Interest rates declined during the early 1990’s. The 6-month LIBOR declined from more than 7 percent in January 1991 to less than 3.5 percent in January 1993 (California State Auditor 1995). Alan Greenspan, then the Federal Reserve chairman, kept the federal funds rate at 3 percent through 1993 and into 1994 (Baker 2009). However, a falling unemployment rate began to raise inflation concerns and Greenspan began to raise interest rates in February 1994. By March 1995, the federal funds rate had jumped from 3 percent to 6 percent (Baker, 2009). The 6month LIBOR jumped sharply, from just under 3.5 percent in January, 1994 to more than 6.5 percent by November, 1994. During the same period, interest on the 5-year Treasury note rose from 5 percent to almost 8 percent (California State Auditor 1995). And then the roof fell in. The strategy, so successful while interest rates were declining, hit Orange County from several directions. On one side, the short-term borrowings, used to finance the longer-term investments, had to be rolled over at higher interest rates. Soon, the short-term borrowing rates were higher than the rates earned on the longer-term investments which the County were locked into. On the other side, the increasing interest rates caused the longer-term investments (used as collateral for additional borrowings) to lose value, resulting in calls by the lenders for additional collateral. The collateral calls stripped the investment pool of cash, and as word spread of the County’s problems, investment pool participants sought to
withdraw their funds. To maintain order, the County decided to declare bankruptcy. It was estimated that the County would lose $1.7 billion, although the actual loss was reduced as a result of a string of lawsuits. As we shall see, speculating on interest rate fluctuations also played a role in Jefferson County’s flirtation with bankruptcy.
Jefferson County Flirts with Bankruptcy Background Jefferson County is located in the heart of Alabama. The largest city and county seat is the City of Birmingham. With an estimated population of 659,503 in 2008, it is most the populous county in Alabama (U.S. Census Bureau 2009). Compared with the State of Alabama, Jefferson County is relatively well-off. The unemployment rate, while higher than that of the United States average, was 10.4 percent in July 2009, versus 10.6 percent for the entire state. Median household income in 2004 was $38,520, $1,458 higher than median household income in the state. Jefferson County has a diverse economy with strong health care, financial services and manufacturing sectors (Sims 2009). Indeed, there are four Fortune 1000 companies headquartered in Birmingham (Birmingham Regional Chamber of Commerce 2009). Despite these strengths, Jefferson County’s prospects are not considered robust. Within the County are widely divergent socioeconomic conditions (Sims 2009). Between 2000 and 2008, Jefferson County lost 8.6 percent of its family-age population (ranging from children five and older to adults 44 and under) (Hansen and Stock 2008). Home values in the County fell 2.4 percent on average in the first half of this year after booming from 2003 to 2006, though the Alabama housing market remains among the stronger ones in the nation (Hansen 2009). The County’s potential bankruptcy does not help matters either.
The Crisis Begins Jefferson County’s financial troubles had its roots in the 1996 settlement of a federal Clean Water Act lawsuit. Jefferson County agreed to take over sanitary sewers from 21 cities, make improvements to plants and 3,100 miles of sewers, and end multiple discharges of raw sewage into streams. The estimated costs of the program were $1.2 billion, to be financed from a combination of small increases in sewer rates, higher utilization from population growth, and debt (the latter about a quarter of the total cost). In 1997, Jefferson County issued $300 million in new sewer debt and $332 million to refinance $301 million in existing sewer debt. More debt was issued in 1999, 2001 and 2002. As of September 30, 2002, sewer debt in Jefferson County had ballooned to $2.706 billion (Hansen 2008; Potter, Hansen, and Velasco 2008), or about $4,087 per capita. As a frame of reference, 9 municipalities in North Carolina with populations over 50,000 had per capita water and sewer debt ranging from $443 to $2,221; among this group Charlotte, whose population is about the same as Jefferson County, was the highest (Department of State Treasurer, North Carolina 2009). Nevertheless, while Jefferson County’s debt burden was high and a definite sign of fiscal stress, it was not a crisis, at least not yet. Nearly all of debt at this time consisted of fixed interest rate bonds. The ballooning cost of the sewer project was caused by many factors. For one, the County went far beyond what was needed for upgrades under the 1996 legal settlement, including $200 million to build a new, 15-tunnel sewer system, dubbed the ―Super Sewer‖ by the public, under the Cahaba River. In addition, 31 cents of every dollar borrowed from 1996 to August 2008 went not to infrastructure, but was either held in reserve for future needs, used to refinance old debt, or used to pay financial advisors and investment bankers who helped the
County borrow money. The fees paid for bond insurance and investment banks, attorneys and advisors were generally considered high (Hubbard 2008). There was also significant political corruption relating to Jefferson County’s debt drama including allegations that the County Commission president at the time obtained a personal loan in exchange for steering business to certain investment banking firms (Richardson and Dade 2008).
Jefferson County Resorts to New Financial Instruments In February 2002, Jefferson County began experimenting with more exotic forms of debt financing. The County issued $110 million in new variable interest rate debt. Along with the new debt, the issuance also included an interest rate swap. In October 2002, the County issued $839.5 million in bonds to refinance its sewer debt. This refinancing converted $839.5 million of the outstanding debt from fixed-rate to variable rate debt, comprised of $298.8 million of auction rate securities and $540.7 million in variable rate bonds. This bond issuance also included three interest rate swaps. Jefferson County engaged in 15 swaps from 2001 to 2004. Most of them were in the form of interest rate swaps, where Jefferson County traded a variable rate for a ―synthetic‖ fixed rate. Figure 1 presents graphically how Jefferson County’s interest rate swaps worked.
In Figure 1, Jefferson County has variable rate debt that carries an interest rate of BMA + 1.00%, but would prefer to pay a fixed rate. J.P. Morgan, which was involved in most of these swap agreements, is the counterparty in this agreement. They are paying a fixed interest of 5.00% on bonds they have, but would prefer a variable rate. Regions Bank is the intermediary that arranges for the two entities to engage in the swap. The way Jefferson County is able to convert its variable rate debt to a synthetic fixed rate is by paying a fixed interest rate of 5.15% to J.P. Morgan. In exchange, they receive a variable interest rate payment of BMA + 0.65%. But they must still pay the variable rate debt of BMA + 1.00% that they owe. So Jefferson County has two outflows and one inflow. The outflows equal 5.15% and BMA + 1.00% for a total outflow of BMA + 6.15%. Their one inflow is the payment of BMA + 0.50%. The BMA’s cancel out—there is no longer a variable interest rate—and the net result is that Jefferson County ends up paying a fixed 5.65% interest rate. Notice that in this 13
example, Regions absorbs 0.15% of the payment from Jefferson County and 0.15% of the payment from JP Morgan to Jefferson County. This 0.30% is the payment to the financial intermediary or the ―spread.‖ If Jefferson County had stopped with the 2002 issues, it might have been able to avoid catastrophe. Unfortunately, it did not. In 2003, the County issued $2.250 billion in securities to refinance existing sewer debt. Most of the 2003 issue consisted of variable rate and auction rate securities, which refinanced fixed-rate debt. The County also engaged in interest rate swaps during the year.
The Crisis Hits The subprime mortgage crisis, which affected almost all state and local governments, has had particularly severe consequences for Jefferson County. The crisis began after credit rating agencies downgraded the bond insurers Financial Guaranty Insurance Corp. (FGIC) and XL Capital, now known as Syncora Guarantee, Inc. FGIC insured $1.56 billion of Jefferson County’s variable rate bonds and Syncora backed $397 million of the bonds (Diel 2008). Auction rate securities often carry insurance because it enhances the credit rating of the issuer of the debt and provides bondholders with additional protection. After the bond insurers were downgraded, Jefferson County was unable to sell its auction rate securities, which, by that time, totaled $2 billion, more than the State of California had sold. This occurred twice in early February of 2008 (Underwood 2008). Without buyers, the interest rates on the bonds soared from 2.08% to between 3.08% and 10% to compensate current bondholders for their inability to sell them quickly (Hubbard 2008). The increase in Jefferson County’s interest rates cost the County an extra $7 million a month in interest payments (Wright
2008). The increased debt burden resulted in each of the credit rating agencies cutting their ratings on Jefferson County’s sewer debt to junk levels. These downgrades further damaged Jefferson County’s delicate financial condition because they made it virtually impossible for the County to refinance its heavy variable rate debt. When the Federal Reserve began slashing interest rates, the County began losing large sums on its interest rate swaps. As discussed previously, the swaps converted variable rate debt to a synthetic fixed rate debt. But with interest rates falling to record low levels, the County began paying out much more than it was receiving (Sims 2008). Additionally, the ratings downgrades required Jefferson County to either post collateral or obtain insurance in order to avoid a swap termination fee (Sigo 2008). The types of financial derivatives that Jefferson County engaged in are not uncommon. Swaps are a way to mitigate risk from interest rate fluctuations. However, the extent to which Jefferson County relied on financial derivatives is extraordinary. The total value of Jefferson County’s swaps is estimated be $5.4 billion (Rappaport and Karmin 2008), more than the amount of debt the County has outstanding. According to Moody’s Investors Service analyst Geordie Thompson, ―We are unaware of any other large municipality that has a greater amount of swaps than debt‖ (Rappaport and Karmin 2008). It was also reported that Jefferson County held the most interest rate swaps–$5.8 billion–of any county in the country (Selway and Braun 2008). The consequences of the County’s problems have been far-reaching. As of August 2009, the County had not paid its sewer debt for 16 months, nor had it made its swap payments (Goodman 2009). Its debt service in fiscal year 2008-2009 was four times the year’s revenues of the County’s sewer system, despite an increase of sewer rates of 397% in the course of a single decade (Spencer 2008). Standard & Poors rates the County’s bonds ―C‖, one category above
default. Moody’s rates the County’s bonds ―Caa1,‖ two categories above default. Its credit rating is below Detroit’s rating. Both ratings are considered junk, making it virtually impossible for the County to refinance its debt. The budget has been hurt particularly hard. One thousand county workers were put on unpaid leave in August because the County did not have enough money to pay them (Wright 2009). The County passed an $808.6 million barebones budget for the fiscal 2010 year. The plan cut spending to the sheriff’s office by 16.4% and put 700 people on a reduced 32-hour workweek (Wright 2009). The consequences of Jefferson County’s fiscal problems have had implications beyond Jefferson County. Financial Security Assurance (FSA), one of the few bond insurers not hurt by the subprime lending crisis, has put a temporary hold on insuring any issuance in the entire state of Alabama, pending the outcome of Jefferson County’s debt problems, thereby increasing the cost of borrowing for other municipalities in the state (Archibald 2008). Bond ratings on projects separate from the sewer system and partially financed by county taxes, such as the BirminghamJefferson Convention Complex, have been downgraded, making it more costly to borrow money in the future. There is even evidence that the fiscal crisis has made it difficult to recruit businesses to the County (Wright 2009).
What Now? The options left for Jefferson County all come with varying degrees of pain. They are receivership, refinancing, or bankruptcy. Jefferson County’s creditors want Jefferson County to appoint a receiver to run the sewer system. The creditors argue that a receiver would be able to extract more money out of the system to pay the County’s debt or raise sewer rates to pay off the debt. The County is vehemently against this option because it would mean losing control over
the finances of the sewer system and potentially result in further spending cuts or tax increases on its citizens (Spencer 2008). The majority of the County Commission supports refinancing, which would involve creditors forgiving the $1 billion already owed to them and refinancing the rest of the debt at a fixed rate. In return, the creditors would get a modest sewer rate increase of 2.8% and $27 million a year from the one cent county sales tax. The county could also file for bankruptcy. However, the bankruptcy proceedings would extend to the entire county, rather than just the sewer system. As a result, the county would lose control over all its revenues and expenditures. Bankruptcy is also likely to affect the future borrowing costs not only of Jefferson County, but other municipalities in Alabama (Spencer 2008). If Jefferson County does go ahead and file for bankruptcy, it would be the largest municipal bankruptcy in American history, exceeding that of Orange County’s. The County has actually found a fourth option in the wake of their fiscal crisis: do nothing. The County has decided to stop paying its creditors and stop making its swap payments. Creditors have taken the case to federal court, but the court ruled that it did not have the ability to appoint a receiver—under federal law, federal receivers are unable to set local utility rates. There is no risk that a government will have to liquidate, making bankruptcy an unappealing option for creditors—one cannot take ownership of a public park for example, giving the County a bargaining chip with its creditors. The result has been stalemate (Goodman 2009).
Underlying Financial Management Issues The Orange County and Jefferson County financial difficulties reached crisis proportions some 15 years apart. Yet, there are many similarities in the underlying financial management
issues causing the problems. Key municipal officials exposed both counties to risks from which they could not extricate themselves when overtaken by external events. These officials either did not understand (or did not want to understand) the implications of making excessive use of risky financial instruments and financial strategies. They failed to seek the advice of independent advisors, relying instead on broker-dealers seeking to profit from the sale of risky Wall Street products.
Orange County Orange County’s problems had their roots in Proposition 13 (approved by the citizens in 1978), which limited the ability of local governments to increase property taxes. Many local governments were squeezed between lower tax revenues, increasing expenditures for education and other services and additional state mandates. The state also relaxed restrictions on investments with the Orange County Treasurer playing a major role in legislation that permitted counties to borrow for investment purposes (Hofmeister 1995). In a January, 1995 hearing, Citron portrayed himself as being under ―great pressure‖ from County officials to produce higher investment returns in a time of tight municipal budgets (Lubman and Emshwiller 1995). Although revenues from investment earnings normally play but a minor role in municipal budgets, revenues from investment returns became a significant element of Orange County’s finances. The California State Auditor characterized the Treasurer’s investment strategies as ―imprudent and reckless.‖ His investments were ―unsafe, highly risky, and extremely volatile, and they lacked the liquidity needed to meet the portfolio’s objectives‖ (California State Auditor 1995). Indeed, it is doubtful whether Citron ever analyzed the risks he was taking. It is not clear
whether Citron convinced himself or was convinced by the investment bankers that interest rates would continue to decline. What is clear is that the degree of risk he took amounted to gambling with the citizens’ money. Analysis by the media in the aftermath of Orange County’s bankruptcy filing indicates that Citron operated as a ―one-man‖ show, receiving no oversight and obtaining advice only from the investment bankers with whom he dealt. In 1987, the County Auditor suggested to the Treasurer that it would be ―prudent‖ to set up an investment advisory committee that included other county officials. The committee was never established, the Treasurer replying that such a committee could ―materially affect investment earnings‖ by taking away his investment responsibilities. Earlier in his career as Treasurer, a grand jury audit suggested that the County supervisors ―exercise greater control‖ over the Treasurer, but that suggestion was also ignored (Lubman and Emshwiller 1995).
Jefferson County Jefferson County’s financial woes stem from its initial decision to issue $2.706 billion in sewer debt to build a sewer system more extensive than that needed to comply with legal mandates. This decision caused the county’s sewer debt to increase to $4,087 per capita, an amount considered to be ―high‖ by most standards. The high debt burden was compounded by the extraordinary use of auction rate securities and swap agreements. When bad luck hit Jefferson County, there was little room to maneuver. About half of Jefferson County’s total debt is in the form of auction rate securities (Wright 2008). These securities are a form of variable-rate debt whose interest rates are reset by periodic Dutch auctions. But if no one bids on the bonds, the interest rates become extremely
punitive. The reliance on financial derivatives by Jefferson County was also extraordinary. The total value of Jefferson County’s swaps is estimated be $5.4 billion, more than the total outstanding County debt. When municipalities begin losing money on their swaps, they are often forced to offer collateral or pay hefty termination fees. This is what FitchRatings says about variable-rate obligations and swap agreements in its water and sewer revenue bond rating guidelines: ―Fitch…believes that both types of instruments can be important tools in a utility’s overall debt strategy…Fitch believes it is imperative that management understand the implications of variable-rate and swap strategies prior to engaging in them, thoroughly evaluating the potential risks and benefits of such instruments…Nevertheless, utilities with a perceived high degree of exposure and/or a perceived lack of understanding and ability to manage such exposure will face tighter scrutiny than those with little or no variablerate obligations or swap agreements outstanding‖ (Quiroga et al. 2008). In a balanced portfolio of debt issues, auction rate securities and swap agreements have a role to play. It is not unreasonable for governments to use auction rate securities and swaps as a component of its debt management. The problem with Jefferson County was not the use of these financial instruments, but rather in the extent of their use and the lack of understanding of county officials of the nature of the risks entailed in excessive use of the instruments. In the final analysis, it is reasonable to conclude that, in addition to the alleged corruption previously mentioned, the county’s problems result partly from a combination of greedy bankers, weak procedures, and poor administration. One writer suggests that county officials ―didn’t properly vet the complicated derivatives and other financing instruments they were being pitched by out-of-state bankers‖ (Johnsson 2009). Another writer noted that the county failed to use competitive bidding in its borrowing as far back as 1997, that its derivatives were certainly
privately negotiated, and that the banks ―raked in as much as $100 million in excessive fees‖ on the county’s interest rate swaps (Selway and Braun 2008).
Conclusions and Lessons Learned Municipal fiscal stress no longer occurs solely in the ―old-fashioned‖ way–through economic contraction and demographic change and insufficient political responses to those factors. Uncontrolled use of risky new financial instruments coupled with sharp changes in interest rates and unusual worldwide financial events can devastate municipal finances virtually overnight. To forestall these events we recommend that all municipal governments adopt the following policies and practices: a. Establish clear statements of investment and debt policies and conduct periodic audits to ensure that those policies are being followed. Simonsen, Robbins, and Kittredge (2002) find that inclusion of debt management factors in debt policies have a powerful influence on their perceived importance by public managers. Given the widespread use of financial derivatives in municipal government, debt policies should be updated to include restrictions on the use of these tools; b. Retain an independent investment advisor, who is registered with the Securities and Exchange Commission as a registered investment advisor. The advisor should get no commissions and make no investments for the entity; c. Establish an independent investment advisory committee composed of persons knowledgeable in investments and public finance; d. Require that investment and debt strategies, policies, and practices be subjected to periodic risk analysis by the independent advisors; e. Require that no investments be made in any type of derivative financial instrument until all risks are explained to staff personal by the independent advisors; f. Act in moderation. Place specific limits on (1) investments in any derivative financial instrument; for example, no more than five percent of the total portfolio and (2) the extent to which reverse repurchase agreements or any other borrowing may be used for investment purposes. In other words, we recommend that government financial officers stick to the basics. Limiting derivatives to a few percentage points of the investment portfolio may not win the ―Finance Person of the Year‖ award for the Chief Financial Officer, but it at least will not bankrupt the
municipality. Fixed-rate callable 20 to 30 year bonds may be dull, and are unlikely to have fierce advocates on Wall Street, but the resulting annual interest payments are at least predictable. In an increasingly unpredictable world with an uncertain financial and economic future, predictability and moderation are bliss.
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