”Statement of

R2

Investments in derivatives such Extended Fund in Section II of that reads: “…the standard of pru- as options, futures, swaps, caps, the revised IPS should be clari- dence to be used by County invest- floors and collars for any of the fied. It reads: “It will be invested ment officers shall be the prudent funds are strictly prohibited. primarily in high grade securities investor standard and shall be ap- The Grand Jury researched the commensurate with achieving a plied in the context of managing an nature of a derivative and found higher yield, while also consider- overall portfolio.” This statement that it is basically a type of security ing preservation of capital.” The appears less restrictive than the ac- the price of which is dependent or Grand Jury believes this places an tual language used in Government derived from some other type of emphasis on yield before safety of Code Section 27000.3 upon which asset. It is a contract between two principal. Also, the use of the word it is based. The language used in parties linked to the valuation of an “primarily” permits investments in the Code pertaining to prudent asset such as stocks, bonds, com- less than “high-grade securities.” investing reads: “Within the limita- modities or currencies. A deriva- The language in the IPS should be tions of this section and consider- tive can be used to hedge risk and clarified to show that yield is not a ing individual investments as part also to speculate. Derivatives can priority over safety, and that invest- of an overall investment strategy, include futures contracts, forward ments will be made only in high- investments may be acquired as contracts, swaps, and options, and grade securities. authorized by law.” The IPS sug- can quickly grow even more com- gests that the standard for measur- What Is A Structured Investment plex involving credit default swaps ing prudence is the performance of Vehicle (SIV)? and collateralized debt obligations. the entire portfolio, rather than risks SIVs are investment funds that The price of derivatives can be associated with individual invest- borrow money by issuing short- extremely volatile. Warren Buffet ments. This language should be term (commercial paper) or medi- once described them as “financial clarified to read that all individual um-term securities at low interest 2008-2009 Orange County Grand Jury rates and then lend that money mortgages, credit cards, student (London), and Rabobank (The by buying long-term securities at loans or other types of debt. How- Netherlands). higher interest, making a profit on ever, an SIV is not a bank, and There are risks with this struc- the difference. SIVs typically invest therefore is not regulated like one. ture however, and one of those in a range of asset-backed securi- It does not have the capital require- risks is solvency. Without strict ties that are a type of debt security ments nor the reporting require- capital requirements, the value collateralized by the cash flows of a ments as banks operating within of the mortgages and other credit specified pool of underlying assets. banking regulations are required instruments the SIV purchases (the The underlying assets are pooled to have. The amount of debt it can assets) could fall below the value of to make them more attractive and raise is unlimited which raises the the notes and commercial paper it to achieve diversification. Some of credit risk to an investor. It is not has sold (the debt raised to finance the more common assets within the surprising that some of the largest the assets). The second major risk pools are credit card receivables, banks in the world were the spon- is liquidity. The risk of borrowing auto loans, student loans, and home sors of SIVs because they could use short-term and lending long term mortgages. A typical structure them as a way to offload mortgages could create a shortage of cash if for an SIV is found in Figure 2. It and other debt instruments from the borrower cannot refinance. This shows the debt issued by the SIV their balance sheets and place them might force the SIV into selling its on the right side of the chart and the into non-regulated SIVs. This al- assets at depressed prices. With the securities comprised in the pool on lowed the banks to expand their rapid decline in housing prices and the left. The debt issued by the SIV own loan portfolios while continu- the turmoil in the credit markets is either commercial paper (CP) or ing to earn from the SIV both a beginning in 2007, solvency and medium-term notes (MTN). management fee and a potential liquidity created major headwinds An SIV operates much like a profit from the credit spread if they for all SIVs. Based on the char- bank in that it borrows money by retained an equity interest. (This is acteristics of SIVs outlined above issuing notes and commercial paper why an SIV is often referred to as a these types of investments do not (the depositors) and then loans that “shadow bank.”) The list of banks appear to be consistent with the money out by purchasing various sponsoring SIVs includes Citigroup County’s priorities of safety and debt instruments (borrowers). In (New York), Dresdner Bank (Ger- liquidity. effect, it is providing the funds for many), Standard Chartered Bank Orange County’s SIVs Orange County began investing in SIVs about ten years ago. With Figure 2 additional commitments in 2007, the County had over $800 million Typical SIV Structure in medium-term notes of SIVs rep- resenting about 14% of the entire •Invests in highly-rated asset-backed debt securities •Issues debt in the form of commercial paper (CP) or medium-term notes (MTN) portfolio. Shown in Figure 3 are the Percent of market values of those investments Capital Structure over the past year taken from the Assets Senior Rating County’s financial reports. Other Debt: Auto Loans than for Whistlejacket (described Cr S e t d u i d t e C n a t r L d o s a R n e s c. 80% A C n P d AAA further in this report) and Sigma, Residential Mortgages MTN Leases the decline in market values during Collateralized Debt Derivatives the period shown is entirely due to Junior A or principal payments received from 10% Debt BBB the SIVs. Equity Capital 10% Notes 2008-2009 Orange County Grand Jury tributions when available as deter- Figure 3 - Orange County Investments In mined by the manager of the fund, Structured Investment Vehicle Holdings Goldman Sachs. The new company Market Value called “Serpentine Funding Lim- ited” expects to “wind-down” its December June December assets over the next four years.) 2007 2008 2008 Other red flags besides the le- CC (USA) Inc. $ 97,000,000 $ 100,000,000 $ 1 00,000,000 verage caused the Grand Jury con- Five Finance, Inc. 113,031,000 6 5,000,000 - cern about the process under which K2 (USA) LLC 199,751,000 5 0,000,000 50,000,000 these investments were reviewed Sigma Finance Inc. 169,487,000 7 5,000,000 - and evaluated. Tango Finance Corp. 160,050,000 165,000,000 50,000,000 The Grand Jury reviewed a copy Whistlejacket Capital LLC 6 9,117,000 6 7,221,000 49,715,000* of the original Whistlejacket of- fering circular (published in 2005) Total $ 808,436,000 $ 522,221,000 $ 2 49,715,000 provided by the Treasurer’s Office. It was reported that Whistlejacket * December, 2008 derived by applying 80% market value factor to principal Capital is incorporated in Dela- consistent with year-end value described in Note 5B of 2008 CAFR. ware and their sole business is the issuance of medium-term notes. It is wholly-owned by Whistlejacket Two SIVs were of particular held within SIVs) were default- Capital LTD that is incorporated in interest to members of the Grand ing on their payments to investors. Jersey, one of the Channel Islands Jury because each had recently en- Whistlejacket went into receiver- under the jurisdiction of the United countered problems making interest ship under British law in February, Kingdom. The following are some payments and had suffered ratings 2008, after the market value of its additional key characteristics of this declines. investments fell to less than half investment taken from the offering: Whistlejacket the value of its start-up capital. • The investment manager is Stan- Whistlejacket Capital, LLC The accounting firm of Deloitte & dard Chartered Bank. It receives was created by Standard Chartered Touche was appointed receiver for a management fee plus the profit Bank, a London-based bank with the failing fund. Today, the bottom potential between the interest significant banking operations line for the County is that Whistle- earned on the SIV’s investments world-wide. Medium-term notes jacket is worth substantially less and the cost of the notes that of Whistlejacket Capital were than its original cost, and there is are issued, if it chooses to retain purchased by the County in Janu- virtually no market in which to an ownership interest. Standard ary and July of 2007 amounting sell it. (The Grand Jury recently Chartered Bank is an internation- to $80 million. The investment, learned that an auction of Whistle- al bank incorporated in England. with its AAA rating from S&P, jacket’s assets was held at the end • The notes are not registered “… was believed to be safe and secure of April, 2009 under the direction under the Securities Act, the by the County, and it offered an of the investment banking firm, securities laws of any state of the opportunity to further diversify Goldman Sachs. Because the bid United States or the securities into asset-backed securities. But price at that auction of 67% of the laws of any other jurisdiction…” Whistlejacket was highly leveraged principal (excluding cash held for • One of the four principal dealers and faced liquidity issues with the distribution) fell below the County’s of this private placement is Mer- downturn in real estate markets. reserve price, the Treasurer chose rill Lynch, who was a defendant Rating agencies began lowering the an alternative option of rolling over in an action brought by the ratings on asset-backed securities, the Whistlejacket investment into County regarding the County’s such as Whistlejacket, as more and a note issued by a new company. bankruptcy. more collateralized debt obliga- According to what the Grand Jury Various types of risks in these tions (CDOs, which are pools of learned, the new note will carry no investments were also disclosed: fixed income assets sometimes interest rate but will make cash dis- 2008-2009 Orange County Grand Jury • “Holders will be exposed to should have been carefully evaluat- rated in Delaware for the sole credit risk relating both to In- ed. The Grand Jury believes that the purpose of issuing and selling vestments purchased by the Par- Treasurer and the oversight com- debt securities. It is a wholly- ent and to Derivatives entered mittees who are charged with dis- owned subsidiary of Sigma into by the Parent with derivative cussing, reviewing, monitoring and Finance Corporation which is counterparties.” reporting these investments, need to incorporated in the Cayman • “Since the Parent may buy assets fully understand their consequences Islands. and the Co-issuers may issue before investing in them. They • The principal objectives of liabilities in a variety of cur- should evaluate how these invest- Sigma are to invest in “bonds, rencies and interest rate bench- ments comply with policy relative notes, debentures, certificates marks, Holders could be exposed to foreign investments and the use of deposit and debt securities of to risks in fluctuations in interest of derivatives. Were any concerns all kinds, entering into options, and currency exchange rates.” expressed about the excessive le- futures and other types of hedg- • The potential liquidity issue of verage being used? The Grand Jury ing transactions, borrowing and borrowing short and lending was interested in whom, if anyone, raising money in any currency, long, was disclosed: “Holders was asking these questions. granting security over its assets are exposed to liquidity risks Sigma to secure borrowings, and car- arising out of the funding by the Sigma Finance, Inc. was first rying on other incidental activi- Co-Issuers of longer-term assets purchased in 2001 and peaked with ties.” with short or medium-term li- a balance of $175 million in 2007. • Among the services provided by abilities.” Sigma was once the oldest and Gordian Knot under the manage- • Whistlejacket plans to make single largest investment vehicle ment contract are “arranging significant investments (up to of its kind and was managed by for Sigma to enter into options, 75% of total) in the structured London-based Gordian Knot. The futures and other derivatives finance industry. This means founders of Gordian Knot were transactions in order to hedge there will be potential invest- two former employees of Citigroup Sigma’s exposure to interest rate ments in asset-backed securities, who pioneered the first SIVs in the and currency risk.” mortgage-backed securities, col- late 1980s. Sigma fell victim to • Sigma was borrowing short and lateralized debt obligations, and the same forces as other SIVs and lending long, the same maturity credit derivatives. defaulted on its loans at the end of mismatch as existed with Whis- The Grand Jury reviewed the September, 2008. Fortunately for tlejacket. June, 2008, portfolio report issued the County, the Treasurer was able • Merrill Lynch was listed as a by the trustees of Whistlejacket, to completely sell the remainder of primary dealer in medium-term Deloitte & Touche. Included in the Sigma SIV in mid-September, notes of Sigma.. the report was a balance sheet that 2008, for 91.5 cents on the dollar, The Grand Jury was unable to shows a debt-to-capital ratio of 10 incurring a $6 million capital loss review a balance sheet of Sigma to 1. It also shows investments on the sale. It was speculated at the but it appears that, based on the scattered across the world from the time that the eventual liquidation descriptions above, the investments U.S. and United Kingdom to Tur- of Sigma’s assets would bring as contained in this SIV, much like key and Singapore. The bulk of the little as 15 cents on the dollar. The Whistlejacket, were scattered all assets were highly rated (at the time Treasurer’s actions were timely to over the world and also involved of the report) with either AAA or say the least, avoiding a potential derivatives. AA ratings. The types of assets in- loss of as much as $65 million. The use of derivatives, invest- clude auto loans, credit card loans, The Grand Jury reviewed an ments in international markets, and student loans, collateralized debt original offering circular from the potential lack of liquidity were obligations and arbitrage CDOs. Sigma for medium-term notes. warning signs for both of these SIV In reviewing the background for Some of the same risks found in the investments. In addition, further Whistlejacket it becomes apparent Whistlejacket documents appear investigation also revealed that 56 that this SIV is full of complicated again in the Sigma offering: of the 58 California counties chose investments with certain risks that • Sigma Finance, Inc. is incorpo- not to invest in SIVs of any sort. 2008-2009 Orange County Grand Jury Los Angeles County chose not to Figure 4 Treasury Oversight venture into the SIV arena because of their complexity, however San Board of Supervisors Diego County made a minor pur- Approves Annual chase of SIVs and shortly thereafter Investment Policy Statement (IPS) Appoints Members of Treasury exited the investment. The Grand Oversight Committee Jury strongly believes investing in Commissioned Risk Analysis by PFM, a Consulting Firm SIVs was imprudent for the County because it was inconsistent with the County’s primary objectives Treasury Oversight Treasurer/Tax Audit Oversight Committee (TOC) Collector Committee (AOC) of safeguarding principal and the Reviews and Monitors Manages County Internal Audits prudent investor standard described Investment Policy Investment Portfolio Directed Audits Receives Treasury Review of Statement of in the Government Code. Investment Report Assets Daily Compliance External Audits Oversight of the Investment Pools Annual Financial Audit Annual Compliance Audit There are several entities Support within County government which Treasury Advisory Committee function to varying degrees in an (TAC): Provides Advice at Treasurer’s Discretion oversight or supporting role of the County Counsel: Provides Legal Opinion of Compliance Treasurer in the management of the County’s investment portfo- lios. These primarily include the Treasury Oversight Committee, the Treasury Oversight Committee of the County Treasurer, the County Treasury Advisory Committee, the (TOC) Auditor-Controller, a representative Audit Oversight Committee, and The creation of the TOC is root- appointed by the Board of Supervi- the Board of Supervisors. Used ed in Orange County’s 1994 bank- sors, the County Superintendent of in support of the oversight func- ruptcy. At that time Treasury Over- Schools, a second representative of tion are internal compliance audits, sight Committees became required the community colleges and school external financial audits fulfilled for each County by Government districts, a representative of the upon request from the Treasurer, Code. More recently that require- special districts, and up to five other or those required by law, such as ment was removed. However, Sec- members of the public. Further, it financial and compliance audits. tion 27130 of the Government Code recommends that a majority of the Outside consultants have also been still recommends that each County public members should have exper- used in the past to perform a risk have an oversight committee tise in public finance. analysis of the Treasurer’s invest- because “…the creation of County Since the TOC has such a ments. All of these various entities Treasury Oversight Committees critical role in the oversight of the shown in Figure 4 appear to present will promote the public interest by Treasurer’s activities, the Grand a comprehensive framework for the involving depositors in the manage- Jury conducted extensive research oversight of the Treasurer’s actions. ment of their funds and by enhanc- into the objectives of the Commit- Given this, why were investments ing the security and investment tee, how it performs in pursuing in SIVs allowed to begin with and return on their funds by providing a those objectives, its bylaws, and its why were they allowed to grow more stable and predictable bal- overall effectiveness. The Grand to such a significant level putting ance for investment by establish- Jury reviewed the TOC minutes for the County’s funds at risk? How ing criteria for the withdrawal of the past ten years, attended meet- was the prudency of investments funds.” Section 27131(a) of the ings as guests, and met with current in SIVs evaluated? How effective Government Code recommends and prior members of the Commit- is the oversight? To find out, the that the size of the committee be tee. It was discovered that, for the Grand Jury investigated further. from 3 to 11 members and should most part, there have been just three be appointed from a pool consisting members (County CEO, Auditor- 2008-2009 Orange County Grand Jury Controller, and Superintendent of of Supervisors was not presented ed by members of the Grand Jury, Schools) for the past year and a with a revised IPS for approval the TOC has become more engaged half. Only recently, in December, until December, 2008. If the TOC in their oversight role. The past 2008, were two new members had expedited the necessary policy two quarterly meetings have been added to the Committee represent- changes by setting appropriate much more active and the addition ing the public. deadlines for doing so, there would of the two new public members has The TOC bylaws state in Rule 6 have been more time to act ac- contributed to more substantive that the Committee will consist of cordingly in this rapidly changing discussion. The current state of the five members including the County investment climate. economy and the volatile financial Auditor-Controller, the CEO, the Rule 27(e) of the TOC bylaws markets have injected a new sense County Superintendent of Schools, state a requirement that “…the of concern about the safety and one representative of the special Treasurer provide the Commit- liquidity of the County’s invest- districts, and one member of the tee with an investment report as ments. In order for these kinds of public. However, in Rule 8 it states required by the Board of Supervi- activities to continue, the bylaws that the BOS may reduce the Com- sors.” The Grand Jury believes that of the TOC should be changed to mittee to three members. During this means the TOC should review reflect a more expanded role with a time when the financial markets that investment report thoroughly specific expectations of its mem- were collapsing under the weight of and understand the activities that bers. Members should be expected sub-prime loans and the economy occurred in the month or quarter. to review the Treasurer’s monthly began a rapid decline, the TOC It should question those activities, investment report and question the could have used a few more mem- discuss them, challenge them, and major investment decisions, as well bers with the expertise to insure assure itself that policies are being as the strategies being employed, the County’s funds were safe and prudently applied, consistently and to insure that plans to safeguard liquid. Nevertheless, the Grand Jury correctly. The information is readily the principal are fully understood. found, based on its interviews and available from the Treasurer with The Grand Jury also believes public review of the Committee minutes, a comprehensive investment report membership on the TOC should there did not appear to be a very posted monthly on the Treasurer’s increase to four members instead of high level of urgency to add to the website. However, the Grand Jury just two. All four public members Committee’s membership. learned in several interviews and should be technically competent in The bylaws consist mostly meetings that reviewing policy was finance and investment principles. of procedural and administrative the limit of the TOC’s oversight. This will achieve a better bal- rules, but Rule 27 defines what the Some on the Committee stated their ance between County and public TOC is actually mandated to do. It function is not to question but to members and serve to enhance the specifically states that, “The Com- “trust” the Treasurer. Members of Committee’s expanded role in the mittee shall review and monitor the the TOC should realize that their oversight of the investment pools. annual investment policy prepared value is in their independence and The Grand Jury acknowledges that by the Treasurer in accordance with if they don’t ask the tough ques- it is difficult to recruit and retain Section 27133.” The Grand Jury tions, who will? How can they say public members due to conflict-of- believes the Committee is carrying they are fulfilling their obligation if interest laws that limit involvement out the responsibility of reviewing they don’t question the Treasurer’s by investment experts. Nonetheless, and monitoring the IPS but is not actions? If they had known that increasing the effort to expand pub- doing so in a timely manner. The they were overseeing investments lic membership in such a critical 2007 IPS was approved by the BOS tied to student loans in Finland area would be worthwhile. in February of that year. The Board or that monthly interest payments The Grand Jury is not advocat- of Supervisors re-affirmed the IPS were linked to the successful use of ing the TOC get involved in the without modification in December, derivatives, or that in the event of day-to-day operations of the Trea-

R3

The Treasurer should participate. (F-4) from the Treasury Oversight Com- exit all SIV investments as mittee soon as practicable. (F-2, F- R.5(b): The investment Responses to F-6 are required 2(a), F-2(b), F-2(c), F-3,) report produced monthly by from the Auditor-Controller and the Treasurer’s Office should the Treasurer-Tax Collector

R4

The Board of Supervi- be reviewed by the TOC. Response to F-7 is required sors should consider the 2008-2009 Orange County Grand Jury The structure of the TOC good accounting principles rent investing climate and meetings should allow for and practices. (F-6) any issues previously raised the Treasurer to be ques- with the Treasurer’s Office.

R6

a): The TOC should Oversight Committee that an annual compliance consider expanding to seven Responses to R-4 (a), (b), (c) audit be conducted that ad- members including four are required from the Board of dresses all elements of the members of the public. This Supervisors Government Code as well as will achieve a better balance Response to R-5 (a), (b), (c) the IPS. The audit should between County and public are requested from the Treasury be conducted by a firm or membership and serve to Oversight Committee firms that have legal as well enhance the Committee’s Responses to R-6 (a), (b) are as investment expertise in expanded role in oversight required from the Board of Su- the types of investments of the investment pools. pervisors and requested from the included in the investment Since the Committee re- Treasury Oversight Committee pools. (F-8, F-9, F-10) cently added two members Responses to R-7 is required of the public, two additional from the Auditor-Controller

R7

The Auditor-Controller major credit agencies. Prop- should insure that financial er due diligence begins with Required Responses statements prepared by the a review of credit ratings; it Treasurer’s Office showing doesn’t end there. (F-11) The California Penal Code investment balances be reg- specifies the required permis-

R8

The TOC, in its ex- tioned as to the portfolio’s (F-12) panded role, should direct performance, recent invest- the activities of consulting Response to R-1 is required ment decisions, and the firms used to conduct in- from the Treasurer-Tax Collector strategies being employed. dependent reviews or risk Response to R-2 are required Since financial markets and assessments of the County’s from the Treasurer-Tax Collec- economic conditions can investment pools. This will tor and the Board of Supervisors, change rapidly, the TOC increase independent and and requested from the Treasury should fully understand at effective oversight and may Oversight Committee all times how the Treasurer help expose shortcomings in Response to R-3 is required intends to “safeguard the future reviews. (F-7) from the Treasurer-Tax Collector principal.” (F-4) and requested from the Treasury

R9

The TOC should insure

R11

The Treasurer’s Office ularly audited. In the event sible responses to the findings and should schedule an annual any future investment bal- recommendations contained in the meeting between the TAC ances or values are called report. The specific sections are and the TOC to discuss the into question, there will be quoted below: safety and quality of the an immediate response or investment pools, the cur- restatement consistent with 2008-2009 Orange County Grand Jury §933.05 2. For purposes of subdivision explanation and the scope and 1. For purposes of Subdivi- (b) of Section 933, as to each grand parameters of an analysis or study, sion (b) of Section 933, as to each jury recommendation, the respond- and a timeframe for the matter to grand jury finding, the responding ing person or entity shall report one be prepared for discussion by the person or entity shall indicate one of the following actions: officer or head of the agency or of the following: (1) The recommendation has department being investigated or (1) The respondent agrees with been implemented, with a summary reviewed, including the governing the finding. regarding the implemented action. body of the public agency when (2) The respondent disagrees (2) The recommendation has applicable. This timeframe shall not wholly or partially with the finding, not yet been implemented, but will exceed six months from the date of in which case the response shall be implemented in the future, with publication of the grand jury report. specify the portion of the finding a timeframe for implementation. (4) The recommendation will that is disputed and shall include an (3) The recommendation not be implemented because it is explanation of the reasons there- requires further analysis, with an not warranted or is not reasonable, fore. with an explanation therefore. 2008-2009 Orange County Grand Jury