Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County.

• Author: Hewitt, Kathryn L.

Reviewed by Kathryn L. Hewitt, cash and investment manager for Prince George's County, Maryland, and member of GFOA's Committee on Cash Management.

Every local government official involved in the financial management of his or her jurisdiction should spend a few hours reading this book. It is an eye opener illustrating once again the effect of too much power concentrated in too few hands and the complacency that occurs based on a successful track record.

Orange County's bankruptcy has been the biggest news in the government arena during the last decade. Citizens awoke to news that their local government was bankrupt. It was unbelievable when they lived in one of the largest, wealthiest counties in the country. This county is now the largest municipal failure in U.S. history. The fate of the county finances was unknowingly vested in the hands of Treasurer Robert L. Citron and a few assistants. Through his management of the Orange County Investment Pool, $1.7 billion was lost.

Philippe Jorion weaves an interesting story of Robert Citron and his world, the growth in power with his successes, the changes in the securities markets, and the effects of leverage. He sets the stage with a discussion of the Jarvis-Gann initiative leading to the passage of Proposition 13 and the quest for revenues from nonproperty tax sources. He continues with the John Moorlach campaign to unseat Citron as treasurer in the 1994 election, and the events leading to the December 1994 collapse.

This book serves as a mini-textbook on the strategies and securities used in the investment of the Orange County Investment Pool. Detailed discussions occur on aspects of investment management such as duration, types of risk, and, of course, derivatives. The types of derivatives that Robert Citron had in the portfolio are explained, including the strategies that led to their purchase.

In most local government investment policies, the investment objectives or guidelines emphasize safety, liquidity, and yield in that order. The safety objective is measured as credit risk, the risk that arises when counterparties are unwilling or unable to fulfill their contractual obligations. A frequently ignored risk is market risk, which cannot be eliminated by diversification. It is a risk that stems from factors that affect all investments but not equally. Interest rate movements are one example of a market risk factor. Market risks can be evaluated and tested. Leading financial institutions...