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Lessons from Orange County’s 1994 bankruptcy: John Moorlach

Lessons from Orange County’s 1994 bankruptcy: John Moorlach

What lessons have we learned 25 years after Orange County’s 1994 bankruptcy?

The economy controls what the government can do. When local government bureaucrats and elected officials believe they can rely on rosy economic trends, that’s when a fiscal calamity is just around the corner. It’s a classic case of the tail wagging the dog.

It takes a few stumbles by some municipalities before others conclude that trying to be a hero by pursuing higher investment yields in the bond market usually results in a disaster.  Investing short-term cash balances should not be a difficult assignment. It’s as simple as keeping funds in a bank or money market fund.

But, when large balances are involved, there’s always a salesperson to entice unsophisticated bureaucrats with the lure of higher yields with a fail-safe gimmick.  One technique is known as the carry trade, where one borrows at a low-interest rate and invests in higher-yielding longer-term bonds. However, one should never underestimate the power of the yield curve and the direct economic forces impacting its direction. And, don’t forget, when interest rates rise, the bonds’ value declines.

As a result of Orange County’s embarrassing and costly implosion in 1994, the Government Accounting Standards Board issued pronouncement Number 31 in 1997. It required that municipalities report their cash and other investments at market values in their audited financial statements. This approach, known as marking to market, was something I vociferously advocated during my 1994 campaign to replace Bob Citron, the Orange County treasurer-tax collector whose disastrous investment strategy caused the infamous bankruptcy protection filing.

The investment of surplus cash would also change dramatically around the nation. Portfolio managers would keep their investments short-term, with a weighted average maturity closer to 30 days. Citron’s average durations were measured in years, not days.

Although the nation has not seen a similar investment faux pas matching Orange County’s, it has seen the power of interest rates and the fixed income market. The liquidity crisis of 2008 had a major impact on short-term interest rates and would make well known a new gimmick provided by slick salespeople, “interest rate swaps,” which led to imploding municipalities.

A famous example is Jefferson County in Alabama. It filed for Chapter 9 bankruptcy protection in 2011 as a result of high rates at the short end of the yield curve that increased borrowing costs to the point of making it unsustainable on a $ 4 billion blended bond issuance. This county, which includes the city of Birmingham, would push Orange County out of first place for the size of a municipal bankruptcy filing.

Three California cities sought relief in a Federal bankruptcy courtroom for old-fashioned reasons: Vallejo in 2010 and Stockton and San Bernardino in 2012 found that pension costs were consuming a massive portion of their annual budgets.

Then there was Detroit, which became the largest Chapter 9 bankruptcy filing in 2013, addressing $ 18.5 billion in debts, mostly for pensions. That pushed Orange County into third place.

Today we are feeling low interest rates over a historically lengthy period in other investment areas. The biggest casualties are the defined benefit pension plans that have assumed high annual rates of return to provide benefits to retirees. It is difficult to achieve an annual rate of return of 7 percent when, as with most public pensions today, a major component of the portfolio is invested in the bond market.  It forces a heavier demand on the equities in pension portfolios to achieve higher returns.

Twenty-five years after the Orange County bankruptcy and the yield curve’s direction is still wreaking havoc on municipalities with unsophisticated and greedy elected officials and union leaders who believed a salesperson who provided a fail-safe gimmick to enhance retirement benefits.

Unfortunately, this time nationally we’re not talking about billions of dollars at risk, we’re talking trillions. So much for assuming you can rely on the economy and the direction of interest rates.

Get ready for more bankruptcy protection filings in the years to come, as the tail does not wag the dog.

John M.W Moorlach, R-Costa Mesa, represents the 37th District in the California Senate.


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