Robert Citron, the infamous former treasurer of Orange County, died last Wednesday at the age of 87. In 1994 he singlehandedly bankrupted the affluent county in sunny southern California by over leveraging his $20bn fund using repo markets and structured OTC derivatives with a $1.6bn paper loss…sound familiar?
As a municipal employee he did not reap personal gain from his actions, and some say he was motivated by ego. Whatever the motivation, his actions and behavior ultimately helped form some of the tenets of FAS 133 as, at the time, OTC derivatives were off balance sheet and not marked-to-market. Any of his speculative activity to create yield would have hit P&L and presumably would not have been kept under cover as long as it did. Depending on the controls around financial reporting at the time, it’s possible that with FAS 133 he either would not have entered into some of the OTC derivatives to begin with or maybe the extent of the losses associated with the speculative derivative positions could have been curtailed.
Also looking back, would Dodd-Frank have stopped this bankruptcy? As an active speculator to leverage his $20bn investment portfolio, Orange County would not have qualified for any end-user exemptions and most likely would have had to post margin against its derivative positions, which also may not have been easy to clear. However that leverage was reportedly only two times, which although surprising at the time for a municipality, is paltry compared to 2008 leverage ratios of thirty times. Presumably he would have been allowed some threshold on collateral agreements, and given the relative low leverage ratio, it’s hard to know if the extent of the loss could have been prevented by margining requirements alone.
During his grand jury hearing, Mr. Citron claimed he was an unsophisticated victim of banks selling him complex instruments and he didn’t understand the risks. Although probably not true, Merrill Lynch had to pay $400MM to settle with the county. Dodd Frank does have several business conduct rules that deal with knowing your client and explaining and documenting the risks. Some of the requirements were watered down in the final rules, for example transparency in the valuation methodology being only on request instead of being in the documentation sent to the client. However, by all accounts Mr. Citron was very sophisticated and it would be hard to see a Swap Dealer today that would not have had a problem meeting the Business Conduct rules.
Stringent accounting rules and Dodd Frank regulation would have gone a long way towards stemming the losses, but when you combine weak internal controls (Mr. Citron was able to deftly move money between accounts) with an individual intent on creating amazing market returns, a recipe for financial disaster is ready to be baked.