When Government Fails: The Orange County Bankruptcy
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Share full text access. Please review our Terms and Conditions of Use and check box below to share full-text version of article. Volume 19 , Issue 2 Spring Pages Related Information. Add to Wishlist. Ships in 15 business days. If those questions had been asked, the problems in Orange County could have been exposed. Most observers were taken by surprise when prosperous Orange County, California, declared bankruptcy in Could this debacle have been averted?
Would answering the following four basic questions have provided early warning signs?
Read When Government Fails The Orange County Bankruptcy
Measures of the safety, health, and welfare of its citizens are not provided; neither are efficiency measures. Executive compensation is not disclosed. Did the county spend more or less on public protection than similar jurisdictions? In plain English, did it have enough money to survive? Organizations with high current ratios are like the proverbial rich widows or widowers of the nonprofit and government sectors, who horde piles of current assets without using them to achieve worthwhile social goals.
Conversely, organizations with low current ratios are likely to be profligate spenders whose appetites exceed their means. But the Orange County balance sheet did not classify assets and liabilities as current or noncurrent. If interest rates were to rise, as they subsequently did, the value of the securities would fall. Indeed, if the securities turned out to be sufficiently exotic, they may not have been able to find any market at all; thus their owners would have been forced to hold them until they matured. Yes, as long as it could afford the interest expense.
But could it?
And because government accounting is darn close to cash accounting, this deficit is a real cash drain. Not a word of explanation accompanies the movement of these billions of dollars. His bet that interest rates would decrease, when in fact they increased, was central to this megadisaster. Not only did the yield on the floaters head south, but the value of the fixed-interest securities he had used to collateralize the loans also diminished.
A bad double play. But, even absent this information, the unexplained movement of billions of dollars sounds an alarm. Its financial resources seem barely adequate to enable it to achieve its goals. Is the organization practicing intergenerational equity? This jawbreaker is meant to judge whether we, the present generation, treat future generations fairly, leaving them some assets and not a big pile of debts.
I proposed to evaluate intergenerational equity with a measure called the inflation-adjusted fund balance. Whether it is desirable to maintain value depends on the organization, of course. In the absence of major increases in productivity or changes in mission, a government in a growing area like Orange County should probably increase—but not excessively—its inflation-adjusted fund balance so that it can provide the same level of services, per capita, over time. Although this measure cannot be computed because the annual report lacks depreciation and inflationary measures, the inflation-adjusted fund balance certainly increased during Orange County appears to be adding to its infrastructure at a very fast rate.
Future generations will need to pay for this furious construction of additional infrastructure. Did they really need it? Are the sources and uses of funds appropriately matched?
Who would finance the purchase of a house with a loan that comes due next year? Apparently the former treasurer of Orange County would. Whereas the rest of us would finance the purchase of a long-term asset with a long-term liability—like a mortgage—he financed the purchase of billions of dollars of longer-term assets with short-term liabilities, thereby mismatching the sources and uses of funds. Further, he matched fixed expenses with variable revenues, a strategy akin to financing the payment of a home mortgage fixed expense with earnings from the stock market variable revenue.
Short and long, fixed and variable—these two mismatches put Orange County in substantial jeopardy, all the more so because of the enormous magnitude of the sums involved. Is the organization sustainable? Diversification is correlated with sustainability because if one aspect of a strategy fails, another can succeed.
The county was highly dependent on moneys earned by its investments. Too much of its capital came from debt, and ultimately, too much of its money was spent to repay it. And the large concentration of interest-sensitive assets on its balance sheet was likely to diminish in value at some time because of the uncertainty of interest rates. A management discussion and analysis report can do the same for other nonprofits and governments by providing early warning signals about ineffective, inefficient, and reckless organizations.
Publicly traded corporations are required to send annual reports and proxy statements to their stockholders, and many send quarterly reports as well. Corporate CEOs typically address open annual meetings of the stockholders, and SEC filings can be accessed easily through on-line services.
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Nonprofit and governmental organizations should follow the corporate model and report to their stakeholders—the donors and taxpayers who fund their efforts. Information should be widely disseminated and easily obtained. Finally, some form of sanctions is required. As is the case for corporations, it seems likely that the federal government would provide the most effective enforcement of these reporting requirements.