What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing in today's video we're going to take a look at one of the most embarrassing and costly cases of bad financial decision making in the history of american Government many governmental entities invest in the stock and bond markets to generate returns, benefiting society, for example, teacher and firefighter pension funds are frequently cited as large investors in hedge funds. All sorts of other public sector institutions are also funded in part by investments overseen by investment managers. Arrangements like this can be very beneficial to public service retirees and the budgets of public services, as they allow them to benefit from the generally rising stock market, but investing public funds doesn't always work out well, for example, in the early days of the corona virus pandemic, A fund managed by allianz on behalf of the new york mta pension plan lost more than 97 percent of its value. This was due to risky leveraged investments made by allianz's investment managers designed to increase returns in today's video.

We're going to take a close look at another, similar case where the consequences were many times greater than the mta disaster. We're talking about the case of orange county. California's leveraged bet on interest rates that ended up putting the entire county in bankruptcy. Orange county is one of the largest counties in the united states with 3 million residents.

It is home to 34 different, incorporated cities and right next door to la the county is bigger than many u.s states, and its financial significance could be described in billions of dollars. In the early 90s, the county faced a revenue problem, their revenue was decreasing while at the same time their expenses were increasing. They had a large unfunded pension program that was worth hundreds of millions of dollars. They were also experiencing reductions in property tax revenue.

At the same time, tax rate increases were unpopular and the county did not want to raise funds by increasing taxes. As a result, the county decided to turn to investments to make up for the budget deficit. In 1994, the county conducted six municipal bond offerings. In total.

These offerings raised about 1.2 billion dollars of capital for the county. These bond offerings were each for a different supposed purpose. For example, about 45 million dollars was raised for the newport mesa unified school district. After raising the funds, the county invested the capital into a pooled investment fund.

The investment fund managed a total of more than 6 billion for several participant depositors from within the county. The goal of the county was to increase the returns of the investment pool above the interest rate of the municipal bond offerings, so as to profit from the positive difference between their own investment returns and their interest payments to bondholders. But in order to make enough revenue from the scheme to completely solve the county's budgeting problems, the investment returns would have to be enormous. In addition, they need to be fixed income securities so that the returns could be counted on each year to meet their own bond obligations and county expenses.

The investment pool strategy to increase returns was multifaceted. First, they took on an enormous amount of leverage over the course of 1994. The leverage ratio of the fund ranged from 150 to nearly 300 percent. At one point, the total assets of the pool exceeded 20 billion dollars.

The value of the portfolio was only 7.6 billion dollars. They achieved this amount of leverage through reverse purchase agreements. In these agreements, the county basically used its assets as collateral to borrow money from counterparties with loans, usually lasting less than half a year with the borrowed money. They would then invest in bonds with maturities of two to five years.

These bonds are more risky, but they also carry higher returns. In this way, the fund borrowed money with short maturities and bought securities with longer maturities earning a positive spread on the interest rates. But this high degree of leverage was not enough on its own. The financial instruments that they bought with the funds obtained through the reverse purchase agreements consisted of up to 50 derivative securities.

Specifically, it invested heavily in derivatives called inverse floaters inverse floaters are themselves highly leveraged derivatives that pay out a coupon that varies in reverse to the prevailing interest rates. If interest rates go down, the coupon paid on an inverse floater goes up, and vice versa, with the investment pool's leveraged portfolio, consisting of more than 100 exposure to these inverse floaters, its returns were highly vulnerable to increases in interest rates in 1993. The county treasurer indicated on a financial statement that the investment strategy was dependent on interest rates remaining low for a minimum of three years. The fed at the time was keeping rates low to allow the economy to recover from the savings and loan crisis from several years earlier.

The orange county treasurer was betting that the fed would continue to be accommodated for many years to come. Interest rates did stay low during 1993 and the fund performed very well. It returned a very high eight percent for the year rivaling or outperforming many stock indexes. However, starting in early 1994, this changed in february.

The fed hiked interest rates by 25 basis points in the first tightening since 1989.. They did not want to overheat the economy in stoke inflation. The economy had already largely recovered and the fed also wanted to make sure that there was room left to decrease rates in future financial crises. The fed's decision to raise rates at that time was a surprise to many in the economy, but gdp was growing rapidly and the stock market was soaring and fed chair.

Alan greenspan was concerned about inflation as a result of the fed's rate hikes the yield on the county's investments began to decline. In addition, because the yields on the inverse floaters decreased, the value of those investments also declined to make matters even worse. The maturities on the investments were in the two to five year range, whereas the reverse purchase agreements that the fund used to borrow money had maturities of about half a year, so the investment fund's cost of capital increased very quickly as interest rates increased. Even at the same time as their investment income was decreasing by the middle of july, the fund experienced collateral calls and reductions in their access to loans of about 900 million dollars throughout the second half of 1994 interest rates continued to rise by december.

The fund's leveraged position had lost one and a half billion dollars. The investment pool was the county's last hope of showing up their finances and instead of pulling the weight of the rest of the budget's difficulties, it incurred an additional cost of massive proportions. On december 6, the county had no choice but to file for chapter 11 bankruptcy protection. This was the largest municipal bankruptcy in u.s history.

Over the course of the next month, the county liquidated the entire investment fund to help pay back creditors after the complete liquidation. The total losses added up to 1.7 billion dollars following the bankruptcy the fcc launched an investigation into the risky investments that the fund engaged in, as well as the disclosures to investors of the municipal bond offerings. They found that the funds took on inordinate amounts of risk. In their highly leveraged investment strategy risks that were not properly disclosed to investors, the bond offerings failed to disclose that the interest payments made to bondholders were dependent on the performance of the fund.

In addition, they found that robert citron, the controller of the county's investment pool illegally misappropriated funds from the pool during 1993, when interest rates remained low. The investment pool's returns were excessively high during this period. Citron transferred 80 million dollars from the pooled investments, which belonged to various governmental entities into the county's own accounts. This money was used for things like making interest payments on previous municipal bond issuances by the county.

It is something of a mystery as to why he did this. The potential penalties for doing so were not much different to the penalties for stealing tens of millions of dollars for personal gain, but citron himself did not personally benefit in the court proceedings. Citron's lawyer said that citron was in some way mentally handicapped and was not capable of fully comprehending the risks involved in his investment decisions. It was also reported that at some point, citron used astrology and consulted a psychic to predict interest rates, and this formed the basis of his assumption that interest rates would remain low.

In the end, he pleaded guilty to misappropriating the funds he was sentenced to one year in prison and fined one hundred thousand dollars as a result of the investment disaster in ensuing county bankruptcy. The county's budget was reduced by 200 million dollars. Three thousand public employees lost their jobs, public services were cut and the county was forced to sustain severe austerity. The county also borrowed an additional 1 billion dollars just to get through the period adding to its financial woes.

For years to come, the people of orange county ultimately paid the price for this disaster, especially the school system. In the end, the seeds of this disaster were planted a long time before citron conjured up the risky investment strategy. The root cause was the county's budget deficit in the first place, somehow the county allowed its pension obligations and other costs to climb to levels that could not be sustained by taxes, especially when property values and thus tax revenue fluctuated adversely this created the need and incentive To take on inordinate amounts of risk, a bad move that ended up costing orange county billions of dollars, alright, guys that wraps it up for this video. If you enjoyed the content, make sure to smash that like button and subscribe for future videos also leave a comment.

Saying what you think the county should have done, instead of engaging in the risky leveraged investment strategy in the meantime. Thank you. So much for watching and we'll see you in the next video wall street millennial signing out.