Orange County's Darkest Moment

Al Jacobs
On the 6th day of December 2019, we celebrated the 25th anniversary of a most memorable day when Orange County descended into bankruptcy. The newspaper article summarized the event as “… one of Orange County’s darkest moments, when the economy hammered an inappropriate investment scheme and the county filed for bankruptcy protection. The historic implosion was caused by reckless investment strategy condoned by most leaders in Orange County.”
 
What led to the default is, in retrospect, easily described. The county’s investment portfolio rested solely in the hands of its Tax Collector/Treasurer Robert L. Citron, a longtime elected public official with no expertise in financial management or investment. 
 
With periodic advice from a major stock brokerage firm, over time he bumbled into a variety of machinations. These included exotic practices, utilizing such concepts as derivatives, reverse purchase agreements and high-risk/high-reward securities – none of which he grasped. 
 
Luckily, his principal investment technique, known as “leveraging” – something he possibly understood – enabled him to borrow money at a particular interest rate and then lend it out at a higher rate. This, of course, is how banks, loan companies and individual mortgage lenders operate. When conducted soundly, it’s a fine way to prudently generate a consistent cash flow. 
 
You must note, however, when in the leveraging business, there’s one procedure you dare not engage in. You must not borrow short term while you lend long term. 
 
Let me explain. Presume you can borrow $1,000,000 at 2% per annum and loan it at 4%. You will earn annual net income of $20,000 [$40,000 received less $20,000 paid]. If, however, the term of your borrowing is one year while the loan you make extends a full five years, there’s a risk. If, for example, market interest rates rise to 6%, your borrowing cost will increase to $60,000 per year while your borrower continues to pay you $40,000. And this is what happened in 1994 to Mr. Citron, who had become emotionally wedded to low interest rates. In February the rate stood at 3.25%; by November it had surged to 5.5%. The short term loans were called by his lenders and the county’s cash deposits proved insufficient to cover the calls. 
 
In an attempt to prevent dissolution of all the county’s assets, the filing of bankruptcy constituted the only recourse. Needless to say, this is not the way to conduct an investment program utilizing taxpayer money.
What I’ve just described is a not uncommon. It often takes a strong sense of discipline to avoid such problemsome arrangements. You might care to know that in 1980 the prime rate under the late Federal Reserve Chairman Paul Volker exceeded 20% per annum. At the time I made 3-year home loans at 20% interest and charged 15 points up front; the annual percentage rate (APR) amounted to about 26½%. I could also obtain personal unsecured callable loans from several banks at an interest rate range of 14% to 15%. 
 
As you see, I had the opportunity to generate additional interest income to myself in the 10+% range. I confess to the temptation of giving it a try. What dissuaded me? The possibility of an unexpected interest rate increase caused me to deep-six the idea. I acknowledge it may have been my sense of fear, rather than my sense of discipline, which led me to avoid the pitfall eventually burying Mr. Citron.
 
While we’re on the subject of leverage, you might care to know there are circumstances where it can be taken advantage of with complete safety. In the mortgage lending business there’s a strategy known as an all-inclusive deed of trust – more frequently called a wraparound. I’ll describe the sort of situation where I’ve used this in the past. I purchased, at a price of $150,000, a single family house from an owner who previously financed it with an FHA home loan. At the time of my purchase, the unpaid principal balance of the loan was $125,000, with the loan’s fixed interest rate at 5%. I gave the seller $25,000 in cash and took title subject to the FHA loan. 
 
In an earlier time FHA and VA loans incurred no alienation provisions, meaning a buyer might acquire it and continue to make the monthly mortgage payments in the same fashion as the prior owner. In short, no due-on-sale clause existed.
 
At some later date, I decide to sell the house. Property values are greater than when I purchased it; I find a buyer who pays me $200,000. By this time, the interest and principal payments I made on the FHA loan, brings its unpaid principal balance to $110,000. I structure the sale as purchase price $200,000; my purchaser makes a down payment of $50,000 and agrees to a $150,000 all-inclusive loan in my favor of $150,000 at an interest rate of 7%. Payments on the old 5% FHA loan remaining against the property will continue to be my obligation.
 
Do you see what my status becomes? After netting $25,000 in cash profits [$50,000 from my buyer less the $25,000 I originally paid upon acquisition], I’m the holder of a $150,000 mortgage loan paying 7% interest, but am still making payments on a $110,000 loan at 5%. What you must realize is my actual loan equity is $40,000 [$150,000 less $110,000], but my annual interest received is $5,000 [$10,500 less $5,500]. Therefore, my $5,000 net annual interest received on an effective $40,000 loan is 12.5% [5,000/40,000 X 100 = 12.5%]. As you see, this impressively enhances my return at no risk.
 
Be aware there’s one detail you must resolve. As current FHA and VA notes now carry a due-on-sale clause, they can no longer be employed in this manner. The underlying loan you wrap around must be without this alienation provision. Of course, even if it does, it may be possible to obtain a waiver from its holder. In this case, your purchase escrow will include such a provision and the sale will be conditional upon its removal. I’ll add another thought to the mix: There’s always the chance some statute may invalidate the due-on-sale clause, thereby permitting the use of the wraparound. California did so some years ago by court order when its Supreme Court, under the direction of then-Chief Justice Rose Bird, declared the due-on-sale clause to be unconstitutional. You might note, however, the ruling did not last. Justice Bird and two of her fellow jurists were removed by the voters, with the alienation provision reinstated by the legislature.
 
And there’s another point to stress – which I hope is obvious: The note you wrap around must have a lower interest rate than the new note you’re creating. Otherwise, you’re the loser rather than the winner. In today’s market, where interest rates are residing in the basement, there may be scant opportunity to employ this all inclusive provision … but keep in mind economic conditions ebb and flow.
 
And now you’re entitled to an important reality. You’ll recall the phrase in the newspaper proclaiming the bankruptcy as “… one of Orange County’s darkest moments.” There’s a better known saying, attributed to William Shakespeare: “It’s an ill wind that blows no good.” 
 
In late 1994, as the nation emerged from a mild real estate recession, many homes previously lost through foreclosure were about to be put on the market for sale. With Orange County suddenly in bankruptcy, the institutional holders of these properties panicked and began auctioning them for whatever prices might be offered. In January of 1995 an associate and I began bidding on condos in the Santa Ana area – and acquiring them – literally at token prices. 
 
For the next several years we acquired units we subsequently sold at triple or quadruple our purchase prices … and during our holding period their annual net rental return averaged 15%. It’s fair to say these did not constitute our “darkest moments.”
 
A final thought: As investments go, real estate is unique. As distinct from corporate securities, your potential profit or loss is – if you choose – in your hands rather than entities over which you lack control.
 
Furthermore, you’re dealing with a product you can see and touch and make decisions about; this may enhance its value. You needn’t simply hope things will go well; you can take the sort of actions required to make things go well.
 

Category:

Add new comment

Beachcomber

Copyright 2024 Beeler & Associates.

All rights reserved. Contents may not be reproduced or transmitted – by any means – without publisher's written permission.