Special Series: Bankruptcy Didn’t Make the Sky Fall In Orange County
March 6, 2012
Editor’s Note: This is the first in a CalWatchDog.com Special Series of 12 in-depth articles on municipal bankruptcy.
MARCH 6, 2012
BY CHRIS REED
Overwhelmed by enormous unfunded liabilities for retired employees’ pensions and health care, local governments throughout California are increasingly contemplating what once seemed unthinkable: declaring Chapter 9 bankruptcy to hold off creditors, to buy breathing time to reorganize and to attempt to reduce costs by any legal means necessary.
This fiscal crisis is outwardly downplayed or dismissed by the state’s public employee unions, who insist that claims of strained finances at all levels of California government are either exaggerated by alarmists unfamiliar with the ebb and flow of pension investment portfolios or the fabrications of anti-government ideologues.
But that these same unions know the crisis is real is manifest in their successful push to get the Legislature to pass Assembly Bill 506, by Assemblyman Bob Wieckowski, D-Fremont. Gov. Jerry Brown signed it into law on October 9, 2011. It ends local governments’ ability to unilaterally declare bankruptcy. Instead, it requires that they first go through a mediation process or hold a public hearing at which they would declare a state of emergency and certify that they will be unable to meet their obligations within 60 days.
This obstacle may make some local officials think twice. But in an era in which San Jose Mayor Chuck Reed – a liberal Democrat – openly speculates about his city being forced to switch to a volunteer fire department, crushing financial pressures are certain to prompt many governments to consider Chapter 9. In so doing, many will look to the most famous municipal bankruptcy in U.S.history: Orange County’s Dec. 6, 1994, declaration that it could no longer pay its bills.
Does Orange County’s Chapter 9 adventure raise any red flags for local governments considering bankruptcy?
Not a one.
But is the county’s highly positive experience truly instructive for local governments in general?
That’s another matter entirely, because Orange County’s story is an unusual one.
The bankruptcy was triggered after failed speculative gambles by county Treasurer Robert L. Citron resulted in a $1.64 billion loss in county investment pools. The immediate reaction was one of shock and dismay, with grave warnings of profound long-term damage to Orange County’s quality of life.
Transportation officials feared crucial highway projects would have to be postponed or cancelled, yielding gridlock in fast-growing south Orange County. A portfolio manager at Scudder Funds said what “the future residents face [is the] cannibalization of every county service.” The executive director of the Associated General Contractors of Southern California said the bankruptcy’s impact was “like a nine on the Richter scale.”
Instead, a mix of new and old county leaders, working with former state Treasurer Tom Hayes and a Salomon Brothers team, stabilized the county’s fiscal picture in fairly short order. They persuaded creditors to hold off a year, froze salaries, put off infrastructure projects, pared services (particularly social services) and reduced the county work force from 18,000 to 15,000, primarily through attrition and dropping vacant positions, not layoffs.
Critics of these moves said county leaders had consistently insulated the middle class and rich from the effects of the bankruptcy, showing a cruel indifference to how cuts in social services hurt the poor. But perhaps because progressives had been making this same argument long before the bankruptcy, it barely resonated beyond the pages of the alternative OC Weekly newspaper.
No Serious Disruption
“There wasn’t any kind of serious disruption over the long term for the residents of the county,” Mark Baldassare, author of “When Government Fails: The Orange County Bankruptcy,” said in a recent interview. “It was shocking, it was surprising, it was something that caused a lot of frustration, but for the average county resident, it didn’t matter that much.”
County leaders made one misstep: asking county voters to raises the sales tax by a half-cent for 10 years to bring in $1.35 billion. Portentously described in a Los Angeles Times headline as a “Referendum on O.C.’s future,” Measure R was rejected on June 27, 1995 in a landslide – 61 percent to 39 percent – by voters incensed that county leaders expected them to pay for a mess they didn’t create. This led to stark warnings from Wall Street credit-rating firms and familiar media complaints that voters wanted services but didn’t want to pay for them.
Soon, however, voters were vindicated, as the county and local agencies that had invested heavily in the county’s investment pools – the biggest creditors – worked out a complex deal. Under the deal, transit and other funds were diverted on an emergency basis and promises were made to give to pool members initial proceeds of lawsuits against Merrill Lynch and other county investment advisers.
On May 15, 1996, a bankruptcy judge gave the go-ahead to the county’s recovery plan. On June 5, 1996, the county was able to sell $880 million in long-term bonds to cover its short-term debts. This allowed county officials to emerge from bankruptcy on June 12, 1996, prompting a jubilant celebration on the steps of a Santa Ana courthouse. On Feb. 27, 1997 – just 814 days after the bankruptcy declaration triggered an avalanche of sky-is-falling warnings from the media, politicians and Wall Street – Fitch Investors Services gave its highest rating, AAA, to Orange County’s investment pools. And on Feb. 24, 2000 – after unexpectedly successful litigation yielded $865 million from the Wall Street firms that worked with Citron on his speculative gambles – the 200 agencies that had invested with Citron were made nearly whole, given checks or wire transfers that brought their recovery on their investments to from 94 percent to 97 percent.
In March 2011, at an American Enterprise Institute forum on municipal debt, Pat Shea, an attorney representing 175 of the cities, water, school and sewer districts with investments, reflected on the outcome: “Five years afterwards everyone, at least on my side – within government, within the family of government – every one of them would say this worked out as well as it possibly could for every member of government.”
The long-term cost to Orange County taxpayers of repaying the $880 million in bonds, of course, has been vast. But even on that front, the news has not been all bad. In June 2005, Orange County’s supervisors OK’d a plan under which the bankruptcy debt would be repaid by 2016, 10 years ahead of schedule.
Yet in reviewing Orange County’s history to determine what lessons it offers, those lessons may not be quite the tidy package that the county’s rebound would suggest.
The circumstances of how the county lost its way are nearly without precedent in U.S. history, having relatively little in common with the retirement benefits crises now bedeviling so many local governments. Citron for years managed to generate above-average returns in the county’s investment pools, with a key strategy to gamble on derivatives that would yield high returns if interest rates remained low. Even as Orange County became, by one report, Merrill Lynch’s biggest customer and its heavily leveraged investment holdings topped $20 billion, Citron continued to operate with little or no scrutiny.
A 1985 Orange County Grand Jury report warning of the risks posed by such an informal investment arrangement was ignored. In spring 1994, warnings by Newport Beach CPA John M.W. Moorlach that Citron and the county risked disaster if interest rates continued to rise were largely disregarded by the media and dismissed by county supervisors and bureaucrats. With Moorlach a candidate to replace Citron as treasurer, the assumption was that his warnings were driven politically. Moorlach’s simple explanation – that Citron’s above-average returns were driven by unusually risky investment strategies – went largely unexplored in the media, who were as shocked as county residents by the December 1994 bankruptcy.
Soon after, with Citron forced out of office, Moorlach appointed to replace him, and new sobriety driving decision-making, the county began to turn the corner – but with immense help from a source unlikely to help current local governments on bankruptcy’s brink. That source: a sharply rebounding Orange County economy.
Venture capital investments tripled in the first quarter of 1995 compared to 1994, and a huge building boom quickly gathered steam. Entrepreneurial high-tech firms, especially in software, aerospace and telecommunications, helped the county move out of the shadow of Silicon Valley and sharply grow international trade. By December 1997, the county unemployment rate was down to 2.7 percent. That year, Orange County had $2.6 billion in annual exports to Japan, South Korea ,China and Taiwan alone. Tax revenue grew steadily, helping push up the county’s total budget from $3.45 billion in 1995-96 to $4.01 billion in 2000-01.
In a 2004 symposium on the 10th anniversary of the Orange County bankruptcy, Moorlach acknowledged the central role of the economic recovery in minimizing the county’s pain.
“Only a county like Orange County could have come back from such a dramatic loss,” he said. “We’re just a dynamic economic powerhouse. Some other counties – I don’t know if they would have fared as well.”
This sharp boom helped the county to escape bankruptcy with relatively modest downsizing of government. Similar bonanzas seem unlikely to come to the rescue of many ofCalifornia’s struggling government agencies.
“Orange County was very unique,” said Baldassare, now president and CEO of the Public Policy Institute of California. “It doesn’t really have much to do” with the present straits facing other local governments in the state.
This doesn’t mean Chapter 9 is a bad choice for local governments overwhelmed by red ink – just that their path back to stability isn’t likely to be as clean and straightforward as Orange County’s.
But there is a powerful lesson to be learned in how Orange County’s leaders behaved after the county emerged from bankruptcy. That lesson: Even after as wrenching an event as a bankruptcy declaration, leaders can’t be counted on to be fiscally responsible. The bankruptcy fiasco was still a very fresh memory when Orange County supervisors and top bureaucrats put the county back on the path toward severe financial problems of a more conventional sort.
The bankruptcy did trigger the changes and cutbacks discussed above. But by July 1999, when I began a two-year stint covering the county government for The Orange County Register, county leaders increasingly showed the same old casual attitudes about spending and oversight – accompanied, incongruously enough, by a vast sense of accomplishment and enormous self-regard.
Bad Habits Return
County Executive Officer Jan Mittermeier, hired in 1995, was a huge improvement over the feckless executives of the pre-bankruptcy era. But the accolades coming her way – including her November 1998 selection as one of Governing Magazine’s Public Officials of the Year – as well as to county supervisors for the county’s rapid rebound produced an insufferable climate at the Hall of Administration. There was a self-congratulatory subtext to interviews, events and board hearings that was impossible to miss. And it continued even as supervisors made decision after decision that treated taxpayer funds cavalierly.
In 1998, the Performance Incentive Program (PIP) was initiated for county workers, billed as an easy, smart way to incentivize superior performance. But an Orange County Grand Jury report in 2003 detailed how PIP amounted to disguised bonus program in which at least 95 percent of employees were being given annual 2 percent raises.
In June 2000, county supervisors voted unanimously to give themselves a 6 percent raise for a third straight year. They also gave nine senior county administrators a 14 percent raise.
But the most devastating decisions involved pensions.
In December 2001, supervisors Jim Silva, Todd Spitzer, Tom Wilson, Cynthia Coad and Chuck Smith – all Republicans who claimed to be fiscal conservatives – approved a 50 percent retroactive increase in the pension formulas for 2,000 sheriff’s deputies, allowing them to earn up to 90 percent of final pay in retirement.
“It’s a mind-blower,” Moorlach said in a recent telephone interview. “Not one of those supervisors called me up [in his role as a member of the county retirement board and as county treasurer] to ask if it was a good idea.”
The pension boost was passed so quickly and with so little fanfare that it didn’t even make the pages of The Orange County Register or The Los Angeles Times. The Nexis news archive shows no contemporaneous media coverage of any kind.
A subsequent pension proposal – to provide a 62 percent retroactive increase in the pension formulas for more than 14,000 county workers – drew far more advance attention. But it was nonetheless enacted in August 2004 on a 3-2 board vote, with the support of self-styled Republican fiscal conservatives Silva, Wilson and Bill Campbell. Their fig leaf: a requirement that affected county employees had to pay more toward pension costs when funding lagged.
Even with that concession, however, the unfunded liability for the Orange County Employees Retirement System soared from $85 million in 1999 to $3.7 billion on Dec. 31, 2009, the most recent figures available on the OCERS website. In the process, the pension system went from being 98 percent funded to 69 percent funded.
Moorlach, who left the county treasurer job in 2006 to replace the Assembly-bound Silva on the county board, expresses amazement at how quickly Orange County’s rebound went sour.
Supervisors didn’t “seem to treat money like it’s real. It’s all funny money, and it will keep coming” was their attitude, he told me.
Moorlach believes the county is now well-managed, with appropriate safeguards and smart long-term planning. But he described how difficult it was for county leaders to replace $48 million in vehicle license fees taken by the state government in June 2011. And he noted that, in the next fiscal year, additional pension costs alone will be $53 million.
As in 1994, he said, “We are dependent on what the investment markets will do.” That year, when Citron’s offbeat investments tanked, bankruptcy became inevitable. “Now, we have to place all our bets on the stock market [portion of the county’s investment portfolio] doing 12 percent a year” – for the indefinite future.
Moorlach’s conclusion: By themselves, board members Silva and Wilson“caused more financial havoc” than the county boards which failed to oversee Citron.
And so in short order, Orange County went from being a nationally recognized model of smart governance to just another California government in which elected officials and top bureaucrats blithely showered taxpayer funds on public employees.
Spending Every Tax Dollar
Chriss Street is an Orange County investment banker who succeeded Moorlach as county treasurer from 2006-2010 and who also voiced alarms about Citron’s strategy before it went haywire. Street has a particularly astringent view of the relevance of Orange County’s second self-created fiscal debacle.
Even in a county buffeted by a recent bankruptcy, “Governments and politicians by their nature will try to find a way to spend every dollar possible and push the liability for that spending into the future, either through borrowing or creative accounting,” Street said in a phone interview.
Far from acting prudently with taxpayer funds, Street said, government officials instead work overtime to enable their spending schemes by crafting narratives that depend on “false impressions of spendable cash flow.”
In other words, they lie now and let the public pay later.
Orange County’s experience in the 1990s does show a Chapter 9 municipal bankruptcy filing can help local governments when it comes to the “pay later” part of this disastrous public policy one-two punch. But the blithe way the county government created a fresh fiasco illustrates a larger truth about the need for citizens to show perpetual and eternal vigilance in monitoring their leaders.
“One of the common failings among honorable people is a failure to appreciate how thoroughly dishonorable some other people can be, and how dangerous it is to trust them,” Thomas Sowell once observed. In less than 20 years, Orange County’s citizens learned this painful lesson twice.
Reed is an editorial writer for The San Diego Union-Tribune, former KOGO talk-show host and editor of Calwhine.com.
CalWatchDog.com’s Special Series on Municipal Bankruptcy: