Lessons Learned from the Bankruptcy
Lessons Learned from the Bankruptcy
Abstract and Keywords
The biggest municipal bankruptcy in U.S. history is now over. There remain some nagging questions about what we can learn from Orange County's mistakes. When the surprising losses in the Orange County Investment Pool were discovered in December 1994, many seemed to think that this strange event could only occur in this unusual suburban county. County Treasurer Bob Citron and the Wall Street investors that lent him money were not the sole causes of the Orange County financial crisis. But Citron was the catalyst for this event. The bankruptcy was made possible by the political, organizational, and fiscal context in which these actors were operating during the 1990s— specifically, the political fragmentation of local government, voter distrust of local government officials, and fiscal austerity in the state government. A resilience of the political fragmentation is seen in the local government reforms that were a product of the bankruptcy. This chapter informs policymakers and scholars about the lessons to be learned from Orange County in order to limit the chances of a repeat of the fiscal crisis.
The biggest municipal bankruptcy in U.S. history is now over. There remain some nagging questions about what we can learn from Orange County’s mistakes. Can it happen again in another big city or suburban region? Why did the financial crisis occur in Orange County rather than somewhere else? Can we identify the conditions of a financial disaster in the making that will help us to avoid future problems? Or are we powerless to prevent an official with poor judgment, such as County Treasurer Bob Citron, from causing big trouble at any time and any place? A main purpose of this chapter is to inform policymakers and scholars about the lessons to be learned from Orange County in order to limit the chances of repeating this fiscal crisis.
I will first examine the reasons for the relevancy of Orange County, and then I will determine the reasons the financial crisis occurred in Orange County at a certain time. Following that, I will make some judgments about the parties that are most responsible for this fiscal crisis and its resolution. Then I will examine the possibility of similar financial problems taking place elsewhere and the likelihood that an event like the Orange County bankruptcy can be prevented in the future.
Orange County is Relevant
When the surprising losses in the Orange County Investment Pool were discovered in December 1994, many seemed to think that this strange (p.217) event could only occur in this unusual suburban county. Since Orange County emerged from bankruptcy in June 1996, there has been a tendency to think that this kind of financial disaster will never happen again. However, I have provided empirical evidence that Orange County is not a peculiar place. This county has much in common with the suburban regions where most Americans live and work. I have also demonstrated that the defining characteristics of the Orange County bankruptcy were political fragmentation, voter distrust, and state fiscal austerity. There is every reason to believe that these three conditions are present in many locales. Orange County happened to have these necessary conditions in large quantities before the problem surfaced in 1994. For this reason, I conclude that its severe financial problem could be repeated elsewhere.
Others have agreed that the Orange County bankruptcy has relevance to the future. An official from Moody’s Investors Service, David Brodsly, placed this episode in perspective, saying, “This has been a huge event: It is really huge. It’s the kind of thing like New York’s default…. It will form the market and market practices for the rest of time as we know it” (California Debt Advisory Commission, 1995, p. 24). An event of this magnitude can offer policymakers and scholars the opportunity to learn from the mistakes, and the recovery from disaster, that occurred in Orange County. It is thus important to summarize what has been learned from this financial crisis so that other municipalities can avoid the problems experienced by Orange County.
The Orange County financial crisis is most applicable to three types of bodies that today include a large number of local governments. They are the large central cities, suburban metropolitan regions, and California counties. The fact that many large central cities are struggling with fiscal strain, as their tax base has eroded and their expenditures for health and welfare have grown, has been studied by many urban experts. However, no large municipality had ever used the option of bankruptcy. Thus, the experiences in Orange County offer some valuable insights.
The Orange County financial crisis is also the first major episode of fiscal strain in a suburban region. This event sends a warning to other suburban governments that they are not immune to such problems. It provides them with an opportunity to compare their current conditions to what was found in Orange County.
Finally, all of the counties throughout California face similar fiscal circumstances because of Proposition 13. As their property tax revenues have declined, they have become more dependent on state funding for (p.218) providing county services. In the 1990s the state government’s fiscal austerity has meant that all of the counties have also had to find new sources of revenue to replace the property tax funds that the state took back. Orange County’s troubled investments can be partly blamed on county government’s efforts to overcome the loss of state funds. This episode also provides an example of how the state government will respond when a county government is in serious fiscal trouble and faces its own budgetary problems. The Orange County bankruptcy crisis thus sheds new light on state and local government relations.
Major Factors at Work
A municipal bankruptcy in Orange County was unexpected for many reasons. Fiscal crises had occurred in large central cities, but they had never been observed in suburban regions. Orange County was supposed to be a wealthy suburb, and the predominance of affluent residents was supposed to shield its county government from problems with revenues, spending, and debts. This county was also known for having Republican officials who were elected by conservative voters, and this political combination should have resulted in tight fiscal management. Nevertheless, a fiscal problem of immense proportions emerged in Orange County. At the end of 1994 the county government became the largest municipal bankruptcy in U.S. history.
The discussion about why the fiscal crisis took place in Orange County should begin with the county treasurer. In fact, previous speculation about why the financial meltdown occurred in Orange County has focused almost entirely on Bob Citron. This long-time county treasurer had earned a state and national reputation as the guru of local government investing. The county pool he managed had achieved higher yields for local governments than any other. The interest earnings had lured most of the local governments in Orange County, and even some public agencies from afar, into the investment pool he managed. His strategy of leveraging funds to borrow risky and long-term securities had succeeded during the 1980s and early 1990s. He then made a series of large, wrong-way bets on interest rates that led Orange County into financial disaster in 1994. Citron was forced to resign in disgrace by the same county officials who had recently supported his reelection and praised his financial performance. It is hard to imagine how financial problems of such an immense magnitude could take place without Bob Citron. The media’s portrayal of the county treasurer as a (p.219) soft-spoken loner who wore turquoise jewelry and consulted psychics about the county’s investment decisions has certainly added to his image as the gambling man who brought down Orange County. However, his personality alone does not fully tell us why Orange County went bankrupt. There were factors in Orange County and in California that explain how the excesses of Bob Citron could go unnoticed and why so many of his actions were tolerated, legally allowed, and even encouraged.
Any analysis of why the financial crisis occurred in Orange County should also consider the Wall Street firms that lent money to the county government. The county treasurer was able to borrow $14 billion through reverse repurchase agreements for the purpose of buying risky securities to invest in the county pool. It was the fact that these loans could not be paid back in a timely fashion that ultimately led to the bankruptcy. Up until this point, borrowing large sums of money was easy for Orange County. The county government was considered a safe bet and, moreover, a very attractive client from the lenders’ perspective. Credit rating agencies gave it one of the highest bond ratings of any county government. In fact, a county bond offering in mid-1994 received one of the highest ratings in the state, even as the investment pool was rapidly deteriorating. They perceived the residents as wealthy and did not see any evidence that a middle-class migration would result in a loss of tax revenues. The taxes, spending, and debt outlined in the county budget also seemed to be in order. The county government appeared to be managed by Republicans and conservatives who had a high regard for careful fiscal management. The kinds of attributes outlined here are generally what large investors prefer. They are also what differentiate suburban regions from the New York model of fiscal crisis. The fact that Orange County had a healthier credit rating than most large municipalities has to be viewed as an important reason why this kind of financial crisis could take place. Not every municipality could borrow the large sums of money that were needed to get into the amount of financial trouble faced by Orange County. What is important is that the fiscal problems of Orange County were hidden, and perhaps to some extent concealed, and they went unnoticed for some time by highly sophisticated financiers. The Wall Street investment firms also failed to recognize that there are other financial risks involved in lending to suburban regions, as well as to large municipalities in California today. As a result, most of the nation’s municipal investment experts had overestimated the county government’s ability and the voters’ willingness to pay the debts.
(p.220) I have taken the position that Bob Citron and the Wall Street investors that lent him money were not the sole causes of the Orange County financial crisis. Bob Citron was the catalyst for this event. The bankruptcy was made possible by the political, organizational, and fiscal context in which these actors were operating during the 1990s— specifically, the political fragmentation of local government, voter distrust of local government officials, and fiscal austerity in the state government. The Orange County financial crisis took place because all three of these factors were present in large degree in Orange County in 1994. However, although these are the necessary conditions, they are not sufficient in themselves. Bob Citron did the damage.
Political fragmentation refers to the structure of local government in this suburban metropolitan region. The area is characterized by numerous local governments and no central political authority within the suburban county. The government entities typically have overlapping geographic boundaries and a duplication of service responsibilities. There is no one local public entity that coordinates all of these different local government activities. The decentralization of political power results in each local government setting its own course for fiscal policies, land use, and the provision of public services and local programs. At times, these local governments compete with one another for new residents and businesses and the tax dollars they can bring to their localities. The end result of this political fragmentation is a local government with a structure that emphasizes local policies and is lacking in regional cooperation.
The evidence presented in this book indicates that Orange County prior to the bankruptcy had layers upon layers of political fragmentation. The county government itself was politically fragmented in several ways. There were five supervisors elected by district to reflect the wishes of their local residents and not the county. There was no mayor representing all of the county’s voters. The county departments did not report to a chief executive officer with direct authority over their actions. Several of the departments were headed by countywide elected officials, such as the county treasurer, who could operate in a fairly autonomous fashion. Outside of the county government, there was the traditional form of suburban political fragmentation. There were thirty-one municipal governments, several single-purpose regional agencies, about two dozen local school districts, and many local special districts. The efforts of the county, cities, school districts, and special districts were not coordinated. Moreover, there was a long history of distrust toward (p.221) the county leaders by other local governments. The relations took a turn for the worse when the investment pool suffered losses and the county froze the funds that were on deposit from the cities, schools, and special districts.
The lack of a central authority within county government is a major reason for the Orange County financial crisis. There was a lack of oversight of the county treasurer by the other county officials. The lines of authority were fuzzy, and the countywide-elected treasurer was not really accountable to either the Board of Supervisors or the county administrative officer. Since the other county officials could not keep track of what the treasurer was doing, they did not have up-to-date information on the county’s finances. They were also not in a position to dictate the treasurer’s investment decisions. In the meantime, the cities, schools, and special districts invested their funds in the county pool with a single focus on what the investments would mean to their own localities. Their political fragmentation was so deep that they did not consult with each other about their decisions to invest their locality’s funds in the county pool. Had the local leaders been in communication with one another about their similar county investment pool decisions, they may have noticed that they were all being made the same promises by the county treasurer of safety, liquidity, and high yield. It would have been evident that the individual promises could not all be kept, given the number of local governments that were in the pool.
The political fragmentation also explains the ways in which Orange County’s government chose to respond to the fiscal emergency. The Board of Supervisors created the position of chief executive officer and a crisis management team of three agency heads to assist a county government that, at the time, lacked a central authority or any internal cohesion. It also explains why the Orange County business leaders had to be called upon to mediate the financial disputes among local governments, and between the local officials and the county officials. There was a basic lack of trust and no open lines of communication between the local public entities.
After the bankruptcy, the plan for fiscal recovery was dictated by the limits of political fragmentation. The local governments could only agree on a plan to divert county tax funds that were supposed to pay for regional infrastructure. The future funding for local public services provided by local special districts, schools, and cities would be spared. The local governments were paid back most of the funds they had invested in the county pool. The cities, schools, and special districts (p.222) would receive the rest of their money if the county government won its lawsuits against the investment firms.
The resilience of the political fragmentation is seen in the local government reforms that were a product of the bankruptcy. The main focus of the reforms in county government was to increase oversight of the county treasurer and prohibit risky investments in the county pool. A chief executive officer was appointed by the Board of Supervisors and thus far has focused on improving fiscal accounting within county government. Otherwise, there has been little in the way of county government restructuring. Most of the cities joined a council of governments to improve their communication. However, the county government and regional transportation agency are not part of this effort. The relations between the local governments and county government are still strained.
Voter distrust is also a dominant feature that helps to explain why a specific kind of financial crisis took place in Orange County. Many middle-class voters have become distrustful of their elected officials and lack confidence in the way they handle the taxpayers’ money. As a result, they are reluctant to raise their taxes except in special circumstances. For instance, they might have supported a tax increase for a specific public service that they perceived as deficient, such as transportation, if the tax funds were earmarked specifically for that service. These voters also do not want government to interfere with personal decisions. Thus, their profile tends to be one of fiscal conservatism and liberalism on social issues. These political attitudes are common in the suburbs and are found among a large cross-section of Democrats, Republicans, and independents. These fiscally conservative voters have elected “New Fiscal Populist” leaders who are charged with representing their constituents’ wishes on tax and spending issues. In order to please their supporters, the elected officials need to maintain or decrease local taxes, but not at the cost of cutting local programs. At the same time, the voters want their elected officials to maintain or increase the public services provided to middle-class residents like themselves. The only area of local government spending that they favor reducing are welfare programs and the local public services designed for the poor. Ideally, these middle-class voters want their elected officials to produce the same or a higher level of middle-class service with a reduction in taxes.
One of the main reasons the fiscal crisis occurred in Orange County is that the elected leaders were under intense pressure from voters to find new revenues so that they could maintain or increase services without (p.223) raising taxes. They endorsed the county treasurer’s schemes to increase interest income through the county pool because it offered them a new source of revenue that was not from taxes. When the state took back some of the county’s property tax funds, these officials went along with the county treasurer’s idea to increase the risk level in the county pool in order to earn even more interest income. The alternative would be to cut services or ask the voters for a tax increase to maintain current service levels. These were unacceptable political risks in this fiscally conservative county. Other local government officials, such as the city and special district leaders, faced similar fiscal and political pressures. They also gave their funds to the county treasurer in the hopes of raising their revenues.
This political climate also explains the responses to the fiscal emergency. From the moment the bankruptcy was announced, the voters were more likely to express anger at their elected officials than fear toward the loss of county funds. Many Orange County residents simply did not believe that the fiscal problem was that serious since it was not felt from their perspective. Many thought that the problem could be solved by cutting waste in government, which they perceived as plentiful, and thus there would be no need to raise taxes or reduce county services. The New Fiscal Populist leaders at the county and city levels were reluctant to suggest a tax increase to pay off the debts.
Fiscal conservatism also guided the recovery plan for the bankruptcy. The voters overwhelmingly rejected a tax increase. Many local elected officials, including members of the Board of Supervisors, went along with the voters and opposed the tax measure. The county leaders also focused spending cuts on government operations and programs for the poor. These were moves that were designed to please the middle-class voters. County tax funds were diverted from long-term projects for the regional infrastructure in the hopes that no one would notice their absence. Local services were maintained at current levels for the middle-class taxpayers, many of whom scarcely noticed that a bankruptcy had taken place. Also, a nontax revenue source is now being sought as a way to pay back the county, cities, schools, and special districts for their losses in the county pool. There are lawsuits pending that seek billions of dollars from the investment firms that did business with the county. This revenue effort should please the fiscal conservatives, although the lawsuits will cost millions of dollars to pursue.
The local government reforms that have been supported after the Orange County bankruptcy also derive from the environment of voter (p.224) distrust. The voters rejected a county charter largely because it would have strengthened the powers of the Board of Supervisors and denied them the power to elect the county treasurer. They may have approved a different charter that strengthened the chief executive officer and limited the authority of the Board of Supervisors. For now, the voters apparently want the power to elect county officials such as Bob Citron, even if they did made a mistake. An alternative explanation is that they expect even worse choices from their county leaders. Voters also overwhelmingly approved term limits for members of the Board of Supervisors. In seven cities term limits passed by a wide margin. The voters also strongly approved a state ballot measure, Proposition 218, requiring that the voters be asked for permission to raise local taxes and fees that were not covered by Proposition 13. Thus, Orange County voters did achieve some reforms after the crisis. Whether or not these changes will reduce the level of voter distrust is not yet known.
The third factor that is important to consider is the presence of state fiscal austerity. The phenomenal growth of suburban regions from the 1950s to the 1970s was highly dependent on generous funding from the federal and state governments. The federal government has been faced with large budget deficits since the 1980s, when expenses rose dramatically and taxes were sharply reduced, and it has been turning over financial responsibilities to the states and local governments. In 1978 Proposition 13 passed in California, and that has affected the ways in which the local governments have become dependent on state funding. Proposition 13 drastically reduced local revenues from property taxes and restricted the abilities of local governments to raise new taxes. For most of the 1980s the California economy was good and the state government provided funds for the cities and county governments to make up for the property tax dollars they lost. In the early 1990s the state government was faced with a high deficit. There were high costs associated with foreign immigration and declining revenues because of job losses during a serious recession. Fiscal austerity forced the state officials to withhold billions of dollars that they had previously given to counties, cities, and special districts. This state action placed local governments in difficulty, since their options were to cut local spending and services or find new revenue sources. Most could not expect their voters to support new taxes or accept the fact that their services would have to be reduced.
Orange County is a suburban region that experienced the impacts of state fiscal austerity. After Proposition 13 the state government’s formula (p.225) for allocating property tax relief provided less support for Orange County on a per capita basis compared with other large counties, such as Los Angeles and Alameda. In the early 1990s the state government took away some of the property tax revenues that had been allocated for the county government, as they did elsewhere in California. The cities, local special districts, and county government all had their state funding allocations reduced.
At the time state funding was shifting, there were demographic and economic changes under way in Orange County that called for increased spending. The population grew rapidly in the 1980s, largely a result of a dramatic increase in foreign immigrants. By 1992 Orange County had among the highest numbers of Asian and Hispanic residents and a large poor population. After a decade of strong job growth, Orange County had fallen into a serious economic recession in the early 1990s. These trends resulted in the need for more revenues to pay for services at just the time that the state government was reducing its financial support to county governments.
It is clear that state fiscal austerity is a factor in why the fiscal crisis occurred in Orange County. The county government was forced to look for alternatives to state funding after the early 1980s. It was receiving a smaller per capita share of the state’s distribution of property taxes compared with other large counties. It was at this time that Bob Citron began to dabble in leveraging and exotic securities as a means to increase interest income in the county investment pool. The state government encouraged these kinds of activities by loosening the restrictions on investments and reporting by the local treasurers. This is perhaps because state government officials knew they could not provide the tax revenues that local governments would need for all of their services. When the state government took back the county’s funds in the early 1990s, the county government responded by seeking more interest income from risky investments in the county pool. Cities and local special districts in Orange County followed the same fiscal strategy to overcome their loss of funding from the state. Their elected officials turned to investing extra funds in the county pool.
The fiscal austerity also resulted in a new precedent for state governments when it came to responding to Orange County’s fiscal emergency. The state government did not intervene in the credit markets, as was the case when other large municipalities, such as New York or Cleveland, faced serious debt problems. The county government instead was allowed to go bankrupt. The state had serious budget problems itself, and (p.226) any form of a financial bailout was ruled out. The role of the state government in the early days of this municipal fiscal disaster was limited to offering financial expertise, such as arranging for a former state treasurer to take charge of the county pool and sending the state auditor to assess the damages that had been done. The state legislature threatened a state takeover however; it also kept at a safe distance from this local government fiscal crisis.
Fiscal austerity also had an impact on the plan for fiscal recovery that was implemented in Orange County. The state government did not lend any money to this bankrupt county government or to any of the local governments that had lost money in the county pool. It did not guarantee loans for the county to reorganize its finances, as was the case when other large municipalities in recent years had faced similar debt problems. The state government passed the legislation that was needed to allow the county government to divert county taxes for bonds that would pay off the outstanding debts. Although there was a threat of the state government stepping in if the local governments failed to develop a plan, the state was clearly reluctant to get involved in providing the funding or credit that was needed.
Local government reforms were also constrained by the fiscal conditions of state government. The state officials tightened the rules that governed investments and reporting by local treasurers.1 They turned back the clock to the days before Proposition 13 and took away the chance for local governments to make additional interest income to replace the property taxes they lost. It is important to note that the state government steered away from any efforts to reform the system of local and state government finance that had contributed to the Orange County financial crisis and made it more difficult to resolve. They did not give back the property tax funds they took from local governments before the recession began, even though the state’s recession was over. The state government did not resolve the issue of how the counties would be able to raise new revenues. The state government, perhaps reflecting its weakened financial condition, also avoided discussions about the realignment of state and county government programs or paying more for the state-mandated services offered by the counties.
There has been a lot of public posturing about who is responsible for the Orange County fiscal disaster almost from the beginning of the crisis. Bob Citron blamed Merrill Lynch and later turned on his former assistant treasurer. The Board of Supervisors blamed Bob Citron and other high-level county officials. State legislators blamed the Board of Supervisors for not supervising. The local officials blamed the county officials. These accusations were often blatantly self-serving. They were from people trying to deflect public criticism, save their political careers, avoid legal sanctions, or win lawsuits. The assignment of responsibility can be an important step in learning why the bankruptcy took place and how it was resolved. With that goal in mind, we look at the evidence collected in this book on the roles that various actors played in this event.
Bob Citron is certainly responsible for the financial collapse of the Orange County Investment Pool. There are many signs of hubris in his annual reports that were submitted to the Board of Supervisors in the 1990s. He bragged about “perfecting the reverse repo procedure to new levels” and earning more than the state treasurer. He took high risks with public funds, presumably to benefit his political career and public standing, that went way beyond the intentions of the state law. His lack of openness with elected officials and the press was inexcusable for a public official. Citron lured many local officials into the county fund with an irresistible sales pitch that was dishonest. That is, he assured them safety and liquidity of funds and a high yield. In 1994 a stubborn reliance on an investment strategy that was no longer working led to bigger bets and huge losses in the county pool. Citron’s actions typify the “woodenheadedness” that government officials have shown in times of tragic failure (Tuchman, 1984).
The members of the Orange County Board of Supervisors also showed a lack of respect for the public offices they held. They were willing to accept vague annual reports from the county treasurer about his investment activities. They praised Citron for helping the county budget with extra interest income without asking how he got the money. They became defensive when there were criticisms of the county treasurer during a heated campaign instead of investigating these allegations. When the county fund collapsed, they pleaded ignorance about derivatives and reverse repurchase agreements, as if this were an excuse for why they approved the borrowing that fueled the risky investment (p.228) policy. During the crisis the Board of Supervisors did place others in charge who were able to maintain order in county government. They also attempted to deflect public criticism by having the newly appointed chief executive officer take the heat on the controversial issues of budget cuts and layoffs. Some of them avoided unpopular stands, such as supporting a tax increase, to extend their political careers. The chair of the Board of Supervisors announced his resignation even while the county government struggled to develop a recovery plan. The Board of Supervisors failed the public on three accounts: proper oversight of county affairs, leadership during the crisis, and willingness to take responsibility for their collective mistakes.
Other county officials also failed in their duties to monitor and report the activities in the county treasurer’s office. The auditor-controller and the county administrative officer were in positions that should have given them keen knowledge of the county treasurer’s operations. The budget director and assistant treasurer have also pleaded ignorance to the details. The fact that Bob Citron did not share all of the information about the county pool was irrelevant, since the interest earnings alone should have been enough of a red flag for these budget experts. They may have lacked the powers to control the county treasurer, but they could have made a stronger demand to the Board of Supervisors, or to the public or media, to investigate his practices.2 For these officials, steering clear of Citron’s risks was the way to play it safe in a county structure that had become addicted to high interest earnings from the county pool.
The investment brokers and financial advisers who worked with the county seemed to have overlooked the fact that their client was a public agency. Merrill Lynch had issued warnings to Citron about the risky nature of his investment strategy and even offered to buy back some of the securities he had purchased. Later they sold him more risky securities when market conditions were even worse. The outside auditor, KPMG Peat Marwick, led the county officials to believe that their finances were sound. The firms that prepared the statements for the county’s bond offerings did not mention the fact that the county pool was a high-risk investment. Standard St Poor’s gave a high credit rating to the county government’s debts only months before the bankruptcy. While some did issue warnings, the private firms seemed intent (p.229) on keeping the county officials they worked with happy while making their commissions. The companies that did business with the county government forgot to put the public before their profits.
The local elected officials in cities, schools, and special districts claimed that they were the innocent victims of the Orange County bankruptcy. To some extent this was true, since they were misinformed by the county treasurer. But there were also actions that showed irresponsibility by these public servants. The cities and special districts voluntarily placed their public funds into the county pool. Some of the school districts, which were required to deposit excess funds, went out and borrowed money to invest in the pool. These local elected officials did not ask probing questions when they became willing participants in the county treasurer’s scheme to earn higher yields. No one was asking how the money was made; these officials only wanted to know how much was being made. It does not seem sufficient for the public officials to say that they trusted the county treasurer. If they were following the rules of prudent investing for taxpayer money, they should have been requiring proof on a regular basis that their funds were safe and could be withdrawn. These were politicians drawn to a revenue source that they saw as a quick fix for fiscal problems. During the fiscal emergency, local officials focused on having their funds returned and showed little commitment to solving county wide problems. To their credit, though, they did forgive the county government of debts and they agreed to wait for lawsuits to be paid in full, which was a key ingredient to ending the bankruptcy.
State officials also need to be held accountable for the financial crisis and the ways in which it was resolved. In the early 1990s the governor and state legislature took back some of the property tax revenues that had gone to counties, cities, and special districts. Then they turned their backs on Orange County, Los Angeles County, and other local governments that ran into financial trouble. The Orange County bankruptcy represented a new low for state involvement in the fiscal rescue of an ailing large municipality. The governor watched intently and dispatched experts to the scene, but he did not offer financial assistance or assurances to shaken residents. State legislative leaders seemed mostly intent on using the financial crisis as an opportunity for political gamesmanship and getting back at Orange County legislators for past partisan battles. The state legislature did, at least, have leaders who saw their way to pass the laws that allowed Orange County to borrow its way out of the bankruptcy. Even here, though, the recovery package (p.230) was held up by partisan bickering over a Los Angeles rescue plan. This was not the finest hour for state leaders, and perhaps it reveals what can be expected when state fiscal austerity leads to such indifference toward local government crises.
The Orange County news media failed to carry out their duties as the “fourth estate” in the months before the bankruptcy. John Moorlach had made very serious allegations about the investment strategies of Bob Citron during the campaign for county treasurer in the spring of 1994. He had claimed that the county fund was being managed in a fashion that was far too risky for government agencies. Later he said that the county fund had a paper loss of over a billion dollars. The county treasurer denied these charges and pointed to past performance as an indicator of his professional expertise. The Los Angeles Times Orange County edition, the Orange County Register, and the Orange County Business Journal were all aware of these allegations. They all prided themselves in offering comprehensive coverage of Orange County issues. They each had reporters on staff who covered business and finance issues, such as derivatives and reverse repurchase agreements. They each had sources in the Wall Street investment firms and county government. Yet not one of them systematically examined Moorlach’s claims to see if they were merely election rhetoric or based on facts. Their defense was that Moorlach’s claims were too complicated for their readers to comprehend or fell between the cracks between the business and government news desks. Later in the year the media would have to explain the meaning of municipal bankruptcy. If an objective local source, such as any one of these news organizations, had brought Bob Citron’s practices into daylight in early 1994, there may never have been a fiscal meltdown in December. These local news organizations did not live up to their role as watchdog for the public.3
The Orange County voters, who expressed so much anger at their county leaders for letting them down, cannot themselves escape blame for the financial disaster. They voted for the county treasurer who gambled with the taxpayer’s funds. They elected the members of the Board of Supervisors who failed to provide oversight and showed themselves lacking in leadership during the fiscal crisis. They presented their local elected officials in the county government, cities, schools, and special (p.231) districts with the impossible task of providing more and better services with no new taxes. They did, in fact, pressure their local officials into providing them with “something for nothing” and ended up with a fiscal strategy that relied on interest income from risky investments. The local voters also showed a great indifference to the people who ran their county government and the necessary functions that it performed for local residents. Moreover, after the bankruptcy, the local voters showed no interest in reforming county government other than by imposing term limits and tax limits. Ultimately, a local focus coupled with a public apathy toward regional governance led to a dysfunctional county government that was described by an insider as “an accident waiting to happen.”
As mentioned in earlier chapters, the Orange County business community played an important role at critical junctures during the financial crisis. The team of three business leaders was critical in facilitating the negotiations between the local government investors and the county government that led to the investment pool settlement. The Orange County Business Council sent its leaders to hammer out the details of a recovery plan that could be agreed upon by the county government, cities, schools, and special districts. Still, compared to the potential for leadership before and after the crisis, the activities of the business community were very limited in scope. Several of the business leaders said there were rumors on Wall Street about the Orange County Investment Pool in early 1994. No one called the county government to ask if there was a problem. Later on, John Moorlach made comments about the amount of interest being earned from the county pool. This should have raised concerns among the savvy investors in Orange County. No one in the business community demanded a full investigation of the county treasurer. During the bankruptcy, the Orange County Business Council submitted proposals for local government reforms. However, the business community was remarkably quiet on the issue of the county charter, and soon after that business leaders dropped their calls for the need for local government restructuring. In sum, business leaders deserve praise for responding to the fiscal emergency, but their actions also show that they lack a sustained commitment to ensuring good government.
There are many others who can claim responsibility for making a positive contribution to the Orange County financial crisis. These are the people who acted in ways that minimized the crisis, speeded the recovery, and initiated much-needed local government reforms. Orange County Sheriff Brad Gates took the lead role in making sure that (p.232) county agencies had the funds they needed to serve the residents. Orange County District Attorney Mike Capizzi went after the county officials for their alleged criminal and civil misdeeds without regard to the implications for his own political career. Chief executive officer Bill Pope joy took on the task of being the point person in the crisis, without pay, and steered the county into its new fiscal reality. Former State Treasurer Tom Hayes restored calm both inside and outside county government when he sold off the risky assets and stabilized the sinking county pool during the weeks after the bankruptcy. The attorneys for the county government and the local government investors, Bruce Bennett and Patrick Shea, worked together to make sure that their clients did not engage in lengthy and costly litigation that would be harmful to local residents. Then there were the skilled financial advisers, such as Chris Varelas, who came up with ideas for ways to fund the bankruptcy recovery without money from the voters or the state. County Treasurer John Moorlach brought back a sensible investment strategy and a reasonable approach to public queries to an office that was in disgrace. Donald Saltarelli answered the call of duty from Governor Wilson and took on the thankless task of acting supervisor when the chair of the board resigned. There was the team of business leaders and consultants who worked closely with Gary Hunt, George Argyros, and Tom Sutton for weeks to make sure that the county government and local governments would reach agreement on a pool settlement. There were also the armies of local volunteers who provided advice on public finance and government restructuring. Orange County was, through their efforts, able to fill the void when government failed.
How Many More Orange Counties?
After the New York fiscal crisis, Terry Clark (1976) published a paper titled “How Many More New York’s?” In the late 1970s there was great concern that the serious financial distress that had occurred in New York could befall other American cities. A similar question should be asked about the likelihood of replicating the Orange County bankruptcy. It is important to know if this new kind of fiscal disaster could happen again. As mentioned earlier, some view the Orange County bankruptcy as an unusual event that could not be repeated elsewhere. I will present some of the reasons why there may be more “Orange Counties” in the future.
(p.233) First, Orange County is not the only local government that has been involved in a risky investment strategy to raise income. Moody’s Investors Service conducted a study in December 1994 and found that fourteen counties in California had been using leveraging or derivatives. They singled out six counties that had engaged in significantly riskier uses of these investment vehicles. These were Monterey, Placer, San Bernardino, San Diego, Solano, and Sonoma counties. The county government in San Diego perhaps came closest to replicating the problems in Orange County. Their $3.3 billion had lost 11 percent of its value in December 1994. They informed their investors that they would share in the losses if they withdrew funds, and they were thus able to avoid the more serious crisis that took place in Orange County (New York Times, 1994a, 1994c). A national survey of 1,450 local governments by Moody’s concluded that Orange County stood out in the amount of money at risk in December 1994. But there were plenty of instances in 1994 of local governments having paper and real losses from investing in risky securities. Cuyahoga County, Ohio, had to absorb the losses of other local government investors and cut its budget by $11 million. A Texas state investment fund faced $70 million in losses because of declining values of derivatives. Financial problems were also noted in small towns in Maine and Minnesota and colleges in Chicago and Texas (New York Times, 1994d).
The concerns about local governments losing money through risky investments seem to have subsided since Orange County declared bankruptcy in December 1994. However, this is because interest rates have been stable or slightly declining in recent years. When the Federal Reserve Board again raises interest rates significantly, then, it is likely that a number of local governments throughout the United States could be exposed to significant losses. We could once again hear about investment losses that result in budget cuts for local governments.
New legislation in California has restricted local treasurers from taking the kinds of risks that led to the fiscal collapse in Orange County. However, the use of leveraging and derivatives are still allowed in some other states. One also cannot assume that that laws governing investments in California are permanent. The state government changed course on local government investing in the mid-1980s, after San Jose experienced losses from risky investments that were constructed in much the same fashion as in Orange County. By the early 1990s the state legislature was back to loosening restrictions on local government investments and reporting. If the Orange County bankruptcy is seen as (p.234) an unusual case that will not be repeated, then the state legislature could again decide to allow more flexibility with risky investments.
Also, it is likely that fiscal problems are more widespread because there were other California counties experiencing deep fiscal problems in 1994. These counties point to significant effects of their recent losses in state funding. Eight small counties were on the verge of financial collapse and had to ask the state legislature for $15 million in relief. The state government turned down their request for a bailout, much as it dismissed the possibility of getting involved in Orange County (New York Times, 1994a). Los Angeles County faced a $1.2 billion deficit and was considering the prospect of closing its public hospitals because it could no longer pay its bills (Lazarovici, 1995). The state legislature then passed a bill that allowed Los Angeles County to raid its county transit funds, much in the same way as it handled the Orange County bankruptcy. Since the Los Angeles County and Orange County crises, there has been little talk of California counties in fiscal trouble. However, the credit for the financial turnaround belongs entirely to the state’s economic recovery.
The basic problem that could cause a repeat of the Orange County fiscal crisis is the system of state and local government finance in California that has evolved since Proposition 13. The state government can provide the funds that local governments need in good economic times, but it is not a dependable source of local revenues in bad economic times. The problems faced by the small counties and big counties such as Los Angeles, San Diego, and Orange are really the same. The state government pulled funds away from these counties during the severe recession. For many local governments, that is when they needed outside funding the most. The next recession may push other counties to the financial brink, if the post-Proposition 13 system of state and local funding is still in place. The fiscal situation for counties has become even worse since the voters passed Proposition 98. This means that even during the good times most of the excess funds go to schools.
An additional reason that events such as those in Orange County could happen again is that many places share the suburban characteristics that contributed to the crisis. For instance, many county governments have a Board of Supervisors whose members are elected in local districts and a county treasurer who is elected countywide. In addition, few county governments have a chief executive officer who has authority over the department heads. It is thus possible that the politically fragmented and decentralized leadership styles that are common in suburban (p.235) regions would be accompanied by a lack in fiscal oversight and accountability. Middle-class voters who demand that local services should be improved without an increase in taxes can also be found in many other suburban regions. Such political pressures on locally elected officials could end in desperate attempts to raise new revenues without asking the voters, as was the case in Orange County. Also, as Steinberg and Lyon have noted, urban counties and large municipalities throughout the nation have been forced by federal and state governments to take on more responsibilities without increases in their financial capabilities (Steinberg, Lyon, and Vaiana, 1992, pp. 2, 3). Many local governments will have even more difficulty making ends meet in the next few years as state governments and federal agencies seek to balance their budgets by turning over the responsibilities for welfare and other services.
Much has been said about how unusual it was that the Orange County voters refused to raise taxes to help their municipality recover from the bankruptcy. Some have argued that voters in other municipalities would have acted differently when faced with bond defaults and the prospects of service cuts. However, at no other time has a fiscal recovery plan for a municipality in fiscal stress been placed in the hands of the voters, as in the case of the Orange County ballot measure for a sales tax increase. There is thus no evidence to support the claim that local voters elsewhere faced with bankruptcy would raise their taxes. It is possible that voter distrust is also high in other suburban regions. Voters may assume, as in Orange County, that the fiscal problem could be resolved with existing funds by cutting what they view as excessive waste in government spending. Thus, it may be misleading to assume that the experience of the Orange County voters rejecting a recovery tax would not be repeated elsewhere.
Finally, the surprising nature of the Orange County fiscal crisis is another reason for believing that a fiscal disaster of this magnitude could happen again in local governments. In other words, there could be financial problems that are well hidden. An official from Moody’s Investors Service, David Brodsly, said, “What brought Orange County down was debt that wasn’t even on the books. It was these reverse repurchase agreements…. That won’t happen again perhaps, but what other kinds of liabilities aren’t being measured and aren’t being recognized that could bring distress? Unfunded pension liabilities? Tort liabilities? Environmental liabilities? Deferred maintenance? Deferred expenditures?” (California Debt Advisory Commission, 1995, p. 23).
(p.236) The Orange County episode suggests that the present way of thinking about the causes of fiscal strain in local government, which generally focuses on the economic characteristics of the municipality and its ability to pay debts, is too narrow for today’s fiscal world. We now know that many other local fiscal problems can surface.
Can We Avoid Financial Disasters?
A major question that policymakers have asked is whether or not anything can be done to prevent financial disasters such as the Orange County bankruptcy. On one side are those who believe that “bad things happen” and there is nothing that can be done to prevent such calamities from occurring again. Bob Citron would be viewed by this camp as the kind of abnormal personality who, from time to time, wreaks havoc in an institutional setting. On the other side are those who argue that there were some fundamental conditions present that permitted Citron to take the unusual actions that led to the financial collapse of the county pool. This places the emphasis on the structure of decision making and other areas in government that can be improved.
The point of view one adopts on this topic has importance for the public policy implications of the Orange County bankruptcy. Those who are more fatalistic say that it is not worthwhile to set up a system to constrain all public servants because of the inevitability of uncontrollable abnormal activities. Those who believe the fault lies with the institutional conditions in which the individuals operate look to making changes based on the lessons learned. I have taken the position that we cannot prevent another Orange County bankruptcy. However, there are many things that can be done to reduce its likelihood in the future.
One way to gain perspective on this issue is to look at other human disasters for common threads with the Orange County bankruptcy. Barbara Tuchman (1984) demonstrates how many serious miscalculations by governments, from Troy to Vietnam, have in common a trait she describes as “woodenheadness.” This shortcoming is defined as “assessing a situation in terms of preconceived fixed notions while ignoring or rejecting any contrary signs” (Tuchman, 1984, p. 7). There are times when powerful government leaders fail to remain open-minded about how well their past decisions fit with current conditions. Thus, they ignore warnings and information that would point to a need for new policies. Powerful positions can sometimes insulate people from the reality that they are in error and, without checks and balances, (p.237) can lead to decisions that are no longer in the public interest. There are many parallels between the “folly” that has occurred in governments at other times in history and the actions that led to the Orange County fiscal collapse. Bob Citron continued to pursue a risky strategy that he thought he had “perfected” when the market had shifted against him. No one in county government was in a position to stop him from making terrible mistakes.
Two human disasters come to mind, one in finance and the other in government, that have strong parallels with the Orange County bankruptcy. The Barings Bank collapse in February 1995 was caused by an employee named Nick Leeson who generated $1.2 billion in company losses from making big bets in derivatives (see Leeson, 1996; Fay, 1996; Rawnsley, 1995; Zhang, 1995). The NASA Challenger space shuttle accident in January 1986 occurred when government officials approved a launch after being warned about a likely O-ring failure by Thiokol engineers (see McConnell, 1987; Presidential Commission on the Space Shuttle Challenger Accident, 1986; Brody, 1986). The Barings collapse and the Challenger accident led to debates about whether one can stop disasters of such magnitude in the future. Since then recommendations have been issued on how to prevent a “rogue trader” from destroying a financial company. New procedures have been developed by NASA to make sure that government officials heed warnings about danger before a launch. The conclusion that was reached from these two disasters is that we can learn from our mistakes and make improvements.
One common thread in all three cases is that they raise questions about the ethics of people who wield power. There was no personal financial gain at stake in the decisions that were made, but career gains came into play. Nick Leeson gambled with his company’s money to make up for past losses and to show his superiors that he was still their “wonder boy.” NASA officials risked the lives of seven astronauts for the sake of avoiding a delay of the space shuttle launch that would place this program in a bad light. In Orange County Citron misappropriated earnings from local governments to the county fund to meet his commitment to the Board of Supervisors to help with their budget problems. These acts revealed individuals in power, left to their own devices, who were trying to achieve personal success and win approval from others.
A large element of hubris led to an unwillingness to heed warnings in all three instances. Future success was assumed based on past experience. Bob Citron ignored the advice of Merrill Lynch and moved (p.238) deeper into his risky strategies. After all, he had always outperformed the market in the past. NASA officials did not listen to the Thiokol engineers who warned that an O-ring problem could occur with low-temperature launches. The launches that succeeded in the past had become an indication of space shuttle safety to NASA officials. Nick Leeson assumed that he could beat the futures market even while he realized that his own actions were affecting prices because they were so closely followed by other traders. He was thinking of the large sums of money that he had made for his company in the past.
The institutions surrounding the actors in these three events failed by not following through on the warnings they received and stopping these disasters from happening. Thiokol engineers pointed out the problems with the O-rings, but the top officials succumbed to client pressures and signaled their approval of the infamous launch. One NASA official had complained, “My God, Thiokol, when do you want me to launch? Next April?” (McConnell, 1987, p. 196). Merrill Lynch acted with similar ambivalence as the broker for Bob Citron. First, a top executive warned about the risks of the county pool and agreed to buy back the risky securities. Later the company continued to sell Bob Citron the kinds of risky securities it had advised against. A civil trial is pending on the actions of Merrill Lynch toward the treasurer.
The news media also fell short in their efforts to provide the public with knowledge about the impending problems in all three cases. A Pulitzer prize-winning journalist noted about the Challenger accident, “The press was somewhat lulled by the many successes of NASA…. The press somehow came to believe that NASA was pretty-nigh infallible” (McConnell, 1987, p. 82). On the Barings collapse, a British trade publication said, “The whole thing might have been avoided had we published last autumn a hair-raising tale of the antics of Mr. Leeson” (Rawnsley, 1995, p. 160). It was mentioned earlier in this chapter how the Orange County news media failed to investigate the serious allegations raised against Bob Citron. We can observe from these facts that the news media may be exposed to institutional problems, but they cannot always be relied on to investigate and report the problems in a timely fashion.
The Barings collapse, the Challenger accident, and the Orange County bankruptcy are all characterized by problems in communication with the top leaders and a lack of adequate oversight of the lower levels of authority. The President’s Commission concluded that the decision-making process that resulted in the Challenger launch was “seriously (p.239) flawed.” In their view, a better system would have highlighted the problems with the O-rings and the higher authorities would have canceled the launch (Presidential Commission on the Space Shuttle Challenger Accident, 1986). As for the Barings Bank collapse, Zhang (1995, p. 156) observes, “Many participants in the derivatives industry believe that the crisis was more a managerial problem than a system or trading problem.” He goes on to describe how the management in London was largely unaware of the trading that Nick Leeson was doing in Singapore. In the case of Orange County, the former chief administrative officer had described the system of reporting from county departments to the Board of Supervisors as “an accident waiting to happen.” The county treasurer was buying reverse repurchase agreements and inverse floaters for the county pool with little oversight or financial control by top officials in the county government.
In closing, the Orange County bankruptcy provides another glaring example of a government leader whose “woodenheadedness” got in the way of reason and actions designed for the public good. The communications and oversight problems that allowed the Orange County Investment Pool to collapse are similar to the conditions that led to the Challenger space shuttle accident and the collapse of the Barings Bank. There were changes made as a result of the two other disasters. After the Barings collapse, financial institutions tightened controls on the trading of derivatives, and to date there has been no repeat of the “rogue trader” incident. NASA instituted a new system for launch approvals and, at this time, there have been no more space shuttle accidents. The reforms resulting from the Orange County bankruptcy have been limited to new restrictions on local treasurers. The soul-searching analysis that occurred after the other financial and government disasters has yet to be seen. It is essential to identify the broad range of policy changes suggested by the Orange County financial crisis. It is the first step in reducing the likelihood that it will be repeated in the future.