THE BANKRUPTCY BUZZARDS
OF
ORANGE COUNTY
Sightings from The Catbird Seat
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December 12, 2004
Bankruptcy lessons in Orange
Before The O.C. came the B.K.
Ten years ago this month, prosperous Orange County, Calif., went belly-up in the nation's biggest municipal bankruptcy ever.
When the dust settled, a couple of county officials served time in jail, the county's investment advisers and auditors paid more than $600 million in fines, and residents of the affluent coastal area - the setting for a popular new TV show - had to borrow heavily to make up more than $1.6 billion in losses while absorbing broad cuts in local services.
The default also shook up investors during one of the worst years ever for municipal bonds. The typical muni-bond mutual fund in 1994 lost 6.7 percent, even after bond interest income, reports researcher Morningstar Inc.
But as investment crises go, this one fizzled, with little lingering impact nationally...
"That first year it raised some eyebrows," said Todd Curtis, portfolio manager of the Tax-Free Trust of Arizona, a bond fund in Scottsdale. "But nothing dramatic came of it."...
Although the debacle exposed institutional failings in the way investment firms, auditors and rating agencies dealt with local governments, no other treasurers made such unwise derivative bets as did Bob Citron in Orange County....
Still, there are investment lessons to be learned from the Orange County debacle before it becomes a forgotten historical footnote. One of which is the importance of diversification, or safety in numbers.
Dozens of mutual funds got caught with Orange County bonds in their portfolios in 1994. But since most muni funds hold so many bonds - about 200 on average - the fallout was limited.
Of course, it also helps that investors eventually were made whole on Orange County bonds, experts say, although county taxpayers will continue to pay off their refinanced IOUs for two more decades.
With the bad news quickly over, it's little wonder the nation's top bankruptcy has been largely forgotten outside California on its 10th anniversary.
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April, 1998
The Orange County Bankruptcy: Who’s Next
Public Policy Institute of California
On December 6, 1994, Orange County became the largest municipality in U.S. history to declare bankruptcy: The county treasurer had lost $1.7 billion of taxpayers’ money through investments in risky Wall Street securities....
Shocked as they were, most observers wrote this off as a fluke, caused by an underqualified county treasurer in a stranger-than-usual California county. It may have been a nasty surprise for Wall Street, they claimed, but not something that could happen again–even in Orange County.
In “When Government Falls: The Orange County Bankruptcy”, PPIC Senior Fellow Bark Baldassare presents compelling evidence to the contrary. In this book, jointly published by PPIC and the University of California Press, Baldassare provides the first comprehensive account of the events that led to the bankruptcy, how the bankruptcy unfolded, and how it was resolved.
Orange County may have provided sufficiently dramatic warning of the dangers of Treasurer Bob Citron’s kind of investment strategy to deter others from following the same path. However, as Baldassare demonstrated, the conditions and resulting imperatives that drove the county to gamble with public funds remain. As the fervor for smaller government, tax limits, and local autonomy grows and spreads, many more municipalities may find the specter of financial collapse looming – especially when the economy takes its next downturn....
October 1, 1998
Merrill Execs Off the Hook in
Orange County Bankruptcy
Merrill Lynch executives will not be sanctioned individually for the firms dealings with Orange County, Calif. , prior to the countys 1994 bankruptcy, according to former SEC Pacific Regional Director Elaine Cacheris.
In an interview during her final days as a regional director for the SEC, Cacheris told Registered Representative the commission viewed Merrill Lynchs failings with respect to Orange County as a firm-wide pattern of negligence--from the trading desk and sales personnel to the investment banking side--that constituted unintentional fraud.
We made a determination that this case was about a collective failure at Merrill Lynch, Cacheris said. We’ve brought the case we had, and were not taking further action.
The SEC accepted a $2 million civil penalty from Merrill in August, settling charges that the firm misled investors when it underwrote $875 million worth of Orange County municipal securities before the county’s $1.6 billion bankruptcy.
The commission charged Merrill Lynch with omitting key information about Orange Countys financial status from offering documents for municipal bonds the county sold to investors. Because the firm had conducted a significant amount of securities business with Orange County, Merrill Lynch executives, including sales managers and risk managers, knew about the county’s risky investment portfolio, the SEC said.
Cacheris said the SEC intentionally focused on the bond offering and ignored allegations of the firms wrongdoing in selling Orange County the risky derivative investments that led to the financial collapse. Those allegations of wrongdoing were the subject of a civil suit Orange County filed against Merrill Lynch, which the firm settled for $437 million in June.
Depositions in that suit show several Merrill senior executives were intimately aware of Orange Countys risky strategy of buying derivatives using leverage. In a series of meetings beginning in late 92, and continuing in 93 and 94, Merrill executives, including the firms chief risk manager Daniel Napoli and head of bond trading at the time, David Komansky (now CEO) discussed on several occasions ways of reducing the countys risk. Although a risk-management group was given responsibility for reviewing derivatives sold to Orange County, in mid-1993 that oversight was turned over to institutional sales.
When you have limited resources and finite opportunities, you need to focus attention on matters of greatest interest to the investing public, Cacheris said. Given the commissions emphasis on municipal markets, our great concern was the lack of disclosure made on a municipal offering. We took note that the county had brought its own lawsuit over the sale of securities and was well-equipped to cover its losses.
Cacheris said the commission also deliberately chose not to pursue G-37 charges against Merrill for alleged illegal contributions made by Merrill employees to Orange County Treasurer Robert Citrons 1994 campaign. We’ve told the courts we would narrowly interpret G-37 because of First Amendment concerns. We want to avoid cases that would create questions of constitutionality.
Some securities attorneys find it curious that the SEC could justify a finding of unintentional fraud and name no individuals as responsible.
Fraud is an intentional act, says Jonathan Schwartz, a former SEC attorney in Marina del Rey, Calif., who now represents brokers. You cannot accidentally commit fraud.... Savvy people at Merrill Lynch must have known that there was a potential for disaster to occur with Orange County’s money... and recklessly disregarded the consequences.
Furthermore, Schwartz says, individuals usually are sanctioned at the same a firm is. Firms don’t commit fraud, individuals do.... This type of resolution appears to be a very thoroughly massaged compromise in which it appears the SEC didn’t want to hurt Merrill Lynch too much, Schwartz adds....
Merrill Lynch has stated that this latest penalty has finally put the matter behind the firm. The firm has already paid a record $467 million to settle private suits and criminal charges in connection with its dealings with Orange County, in addition to reimbursing institutional investors who invested in the failed bond offering.
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MORE TO COME
Meanwhile, you can peruse more bankruptcy buzzard poop by flying over to....
Conseco: Birds in the Trailer Park
Merrill Lynch: Beware, this bull is for the birds!
Office of the U.S. Trustee vs. Harmon
The Rise & Fall of Summit Communications
The Catbird Recommends: Sidney Skolnick’s excellent series entitled The Bankruptcy Bordello...
www.skolnicksreport.com/bankbord-1.html
www.skolnicksreport.com/bankbord2.html
www.skolnicksreport.com/bankbord.html
www.skolnicksreport.com/bankbord4.html
www.skolnicksreport.com/bankbord5.html
www.skolnicksreport.com/bankbord6.html
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Last Update June 27, 2007, by The Catbird