Two disturbing aspects of the Orange County financial debacle, both revolving on accepting responsibility, deserve attention.
For one, users of the credit rating services of Standard & Poor's Corp. and Moody's Investors Service Inc. hardly can take reassurance in knowing Orange County has given them no reason to change their policies in rating such debt.
For the other, Orange County, while filing suit against Merrill Lynch & Co. to recover $3 billion in losses from the risky leveraged strategy, has forgotten its own liability to investors in its securities who relied on its trust. Regardless of whether the county wins anything from Merrill Lynch, investors should have cause to hold the county responsible for their losses.
In terms of the rating services, both Vladimir Stadnyk, executive managing director-public finance at S&P in New York, and Barbara Flinckinger, assistant director and manager-Far West regional ratings and public finance at Moody's in New York, said in interviews the situation in Orange County has resulted in no change in the policies the companies use to rate local governments. (Only last summer, for instance, both companies gave the county their highest short-term rating in regard to a $600 million taxable note issue.)
The two explained the situation in Orange County prior to the revelation of the unprecedented losses raised no red flags alerting them of the need for more scrutiny. No warnings? Among the warning flags the raters outrageously ignored:
The Orange County investment pool's $8 billion in capital made it one of the largest single funds in the nation, excluding its leveraged position. But its huge leverage should have given it even more notoriety with $12 billion in borrowing boosting the pool's size to $20 billion.
All of this was run by a sole person, Robert L. Citron, an elected treasurer and a politician with no appropriate financial credentials attesting to his knowledge of complex and risky investment strategies.
The highly leveraged investment strategy Mr. Citron used was rare among local or state governments, even unique apparently, as neither S&P nor Moody's has yet identified another entity with such big overleveraged strategy in use.
The policies and objectives of the investment pool were unclear: Was the pool supposed to be a money-market type fund holding sacred the value of the principal, or a longer-term fund taking interest-rate risk to enhance return?
The pool's performance was not measured against the market or appropriate benchmarks. So how could the raters judge the effectiveness of Mr. Citron's strategy? They couldn't.
John W.M. Moorlach, who opposed Mr. Citron in last spring's election and made the pool's riskiness the campaign issue, noted at the time the risk of rising interest rates and increasing calls on the pool's collateral were harming its liquidity; and he presciently forecasted the pool's ultimate $2 billion-plus loss.
Last year's rising interest rates caused the worst fixed-income market in 15 years, resulting in widespread loses to investors. Yet, Mr. Citron was presumed by the raters to be immune from it or outsmarting it. The rating companies should have called on their analysts in other departments who rate publicly available money market funds, mutual funds and other investment funds. But neither took advantage of this expertise to examine the pool.
In a seemingly unconnected matter, S&P last year began with some ballyhoo attaching an "r" rating to those securities it felt were subject to particularly volatile returns because of their market sensitivity. Yet, it neglected to extend the implications of its "r" mark to one of the most sensitive funds in the country.
Without question, the credit ratings proved worthless on Orange County. Any user of them has to wonder how reliable the companies' recent assertions that no other situation in the order of Orange County is out there lurking. The raters' policies and processes need tougher internal scrutiny and improvement.