A serious risk every investor should be worried about today
From Jeff Clark in Growth Stock Wire:
Leverage destroys. Just ask Robert Citron.
In 1993, Citron was a hero. He was a public servant who discovered a way to earn high returns in a declining-interest-rate environment. While other municipal treasurers were struggling to earn any sort of return at all, Citron was cleaning up. The gains on his investments made up for any shortfalls in his county budget, kept several county government programs alive, and eliminated any talk of raising taxes.
Citron’s strategy wasn’t all that complicated. He put county money into Reverse Purchase Agreements (RPAs) and Floating Rate Notes (FRNs) that were designed to increase in yield as interest rates fell. He juiced the yields even more by leveraging up (borrowing money) to invest in these securities. After all, if he could borrow funds at 3% and generate a 6% return, leverage was a good thing.
Citron was so successful that neighboring municipalities entrusted him with their funds in the hopes of receiving equally high returns. And they did… for a while.
But in February 1994, the Federal Reserve Board raised short-term interest rates by 0.25%. Liquidity disappeared from the RPA and FRN markets… And Citron’s investment portfolio blew up.
Many of his securities lost 60%-80% of their value.
Citron was convinced that if he could just hold on until conditions returned to normal, everything would work out all right. But he didn’t have the luxury of time. You see, he had borrowed money to make those investments. The sudden drop in value made his lenders nervous, and they wanted Citron to either put up more collateral or liquidate enough of the securities to pay off the loans.
His county didn’t have any more collateral. So Citron was forced to liquidate for pennies on the dollar. The money he received wasn’t even enough to pay off the loans against the portfolio.
A few months later, Citron resigned as Treasurer of Orange County, California. And Orange County became known as the largest municipal bankruptcy ever in the United States.
But here’s the thing…