Report 94026.3 Summary - March 1995

Orange County:

Treasurer's Investment Strategy Was Excessively Risky and Violated the Public Trust

HIGHLIGHTS

The treasurer:

  • Violated the basic principles of prudent investing.
  • Made investments that were unsafe, highly risky, and extremely volatile.
  • Leveraged the portfolio more than 2.7 times and invested more than 40 percent in inverse floaters and other structured securities.
  • Violated his trust responsibilities by altering accounting records and misallocating earnings and losses.

The Orange County (county) treasurer is responsible for receiving and keeping safe all funds belonging to the county and other monies deposited with the treasurer. However, we found that the former treasurer pursued an investment strategy that violated the basic principles of prudent investing, which are safety, liquidity, and yield, in that order. In fact, his investment strategies were diametrically opposed to these principles. The former treasurer's investments were unsafe, highly risky, and extremely volatile, and they lacked the liquidity needed to meet the portfolio's objectives. Further, he sacrificed safety and liquidity in a failed strategy to capture higher yields. The former treasurer did this by leveraging the portfolio more than 2.7 times and purchasing highly volatile inverse floaters and other structured securities that comprised more than 40 percent of his investments.

According to our investment consultants, the former treasurer's investment practices were inappropriate for the county's short-term investment pool and exposed the pool participants to unnecessary risks. As a result of the former treasurer's imprudent and reckless investment strategies, the county and other participants in the treasurer's portfolio incurred losses of $1.69 billion, which caused the county's bankruptcy. Ultimately, these losses will have far-reaching effects, including the loss of jobs and the reduction of critical local government services.

Furthermore, we found the following:

  • The former treasurer violated his trust responsibilities to participants in the investment pool. When the county and other public entities deposit their funds into the county treasury, a trust relationship is established between the treasurer and these entities;
  • The treasurer's office altered county accounting records for investment pool interest earnings. As a result, the county's general fund received approximately $93 million more interest earnings than it was entitled to receive from the investment portfolio;
  • The treasurer's office inappropriately transferred securities from the county's specific investment account. At the time of the transfers, the county's securities had accumulated a $271 million loss that was shared by all pool participants;
  • Eight of the 14 brokerage firms that we surveyed reported that they had revenues of at least $21.3 million in 1994 and $46.3 million in 1993 from financial transactions with the county. The remaining 6 did not provide compensation information. Further, we believe that most of the firms did not disclose all their compensation earned on investment transactions with the county; and
  • The county estimated that approximately $23.7 million will be spent for bankruptcy-related costs through June 30, 1995. The county retained ten firms to provide various services, including legal services for the bankruptcy, litigation services, and advisory services.

Recommendations


To improve the operations of the Orange County treasurer's office, we recommend that the board of supervisors direct the treasurer's office to prepare a comprehensive investment policy. In part, the policy should do the following:

  • Establish guidelines to achieve safety, liquidity, and yield while diversifying the portfolio, preserving capital, and maintaining cash flow;
  • Limit the use of reverse repurchase agreements and ensure that they are in accordance with existing statutes and restrict the purchase of derivatives and other structured instruments;
  • Specify authority and accountability over investment practices by defining prudence and detailing fiduciary responsibilities for the treasurer;
  • Require a competitive bidding process for brokers and dealers;
  • Create an investment advisory committee independent of the treasurer's office; and
  • Require the treasurer to report, at least quarterly, on the investment activities and holdings to the board of supervisors, the advisory committee, and pool participants.

In addition, we recommend that the board of supervisors establish strict rules regarding ethics, conflict of interest, and asset safekeeping for all the county's investment activities, and adopt and approve the treasurer's comprehensive investment policies. Furthermore, the board should rectify the inequities caused by inappropriate interest allocations and the transfer of the county's losses to other pool participants and ensure that future allocations of interest earnings are accurate. Finally, the board should restore the $73 million to the Teeter Plan taxable note repayment fund that was inappropriately transferred to the county's general fund.

To improve the investment practices of local governments, we recommend that the Legislature amend the California Government Code. A few of our key recommendations are to:

  • Require written investment policies for all local governing bodies to ensure that safety and liquidity are paramount to yield;
  • Limit the use of reverse repurchase agreements to 20 percent of the portfolio and only for specified purposes, and restrict the purchase of derivatives or other structured instruments;
  • Establish and define a prudent person rule for local investment officers;
  • Require investment reports, at least quarterly, to the governing body and investment participants; and
  • Prohibit the issuance of taxable or nontaxable debt for speculation or risk arbitrage investment purposes.

Agency Comments


In its response, the county states that it generally concurs with the findings and recommendations and discusses the actions that have already been taken to address the deficiencies. However, the county's auditor-controller disagrees with the appendix to the report concerning the transfer of restricted funds. The county states that its staff is researching this and will advise us of the outcome later.


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