Orange County Fund’s Plunge Draws Scrutiny

The problems at Orange County’s investment fund drew mounting concern and scrutiny Friday as investors, members of Congress, federal regulators and credit monitors assessed the full implications of a stunning $1.5-billion plunge in the value of the fund’s holdings.

While county leaders continued to call for calm, four top investors in the troubled county-managed fund moved to oversee future dealings on behalf of 185 cities and special districts that had pooled their money for investment purposes.

A major Wall Street credit rating agency signaled that it may lower the ratings of Orange County bond issues, an action that could make it more costly for cities and agencies to borrow money.

In other action Friday:

* The Securities and Exchange Commission launched an informal inquiry into the situation.

* The new chairman of the Senate Banking Committee announced that congressional hearings will investigate whether limits should be placed on the use of public monies in the complex financial instruments that have helped drive down the value of Orange County’s previously high-flying fund.

* An Orange County assemblyman said he will introduce legislation in Sacramento on Monday to curb the risky investment strategies used by Treasurer-Tax Collector Robert L. Citron, who continued to face calls for his resignation. Citron remained locked in his office; sheriff’s deputies ordered reporters away from his door.

* Nervous investors--who directly or through mutual funds own tax-exempt municipal bondssold by Orange County or related agencies--flooded phone lines of large funds such as the Franklin-Templeton Group of Funds in San Mateo.

County treasury officials still were reeling from their explosive disclosure Thursday that risky investment maneuvers had combined with sharply rising interest rates to produce losses equivalent to 20% of the money invested by various government agencies. On Friday, they visited with their major bond underwriters.

“I’m not going to make any dire predictions,” said County Administrative Officer Ernie Schneider, who has hired an outside investment adviser to assess the potential damages. “I think we’re telling people the straight situation. We’re not trying to hide it from anyone. We’re just laying it out.”

Although no agencies had pulled out of the fund Friday, some city officials with money in the portfolio say they now wish they had withdrawn earlier this year, when interest rates began rising and it was becoming apparent that the fund’s bets were wrong.

“In 20-20 hindsight, I should have done more, but the pool looked good,” said David Dixon, the city manager of Orange, who said he realized when he took the job in March that the city had too much money in the fund. He earlier pulled $7 million of Orange’s $31-million investment out of the fund.

“I was the new guy in the county and was told not to rock the boat,” Dixon said.

SEC officials would not be specific about the nature of their inquiry.

“In general, we look for a lack of disclosure from whoever is marketing the securities to a government entity or a lack of disclosure from the government entity to its bondholders,” said commissioner Richard Roberts. “I don’t know too much about the Orange County situation, but my current concern is that state and local governments are using too many volatile financial instruments.”

At issue is the county’s massive use of leverage, or money borrowed short-term, to buy long-term bonds in a bet that interest rates would decline this year. As rates instead have rocketed, the fund’s portfolio has tumbled in value.

In addition, the county’s holdings of $8.5 billion in “derivatives”--investments that typically involve more complex bets on the direction of interest rates--have sparked renewed criticism of the often volatile hybrid securities, which have caused losses for myriad other investors nationwide this year.

Although the county’s investment strategy produced above-average returns for its investors while interest rates were falling from 1990 through 1993, national financial experts question whether investors had a clear understanding of the risk that Citron was taking with their money.

“I’ve been in contact with folks who had invested in Orange County and asked them if they knew the risks and they’d always say, ‘I don’t know if it’s good or bad, but (Citron) has always impressed me,’ ” said Jeff Spies, treasurer of St. Petersburg, Fla. “The lack of understanding had always bothered me.”

A measure of how dire Orange County’s situation has become is reflected in how rapidly the fund’s cash holdings have dwindled in the past month. At the end of October, the assistant treasurer told an investor that the county had $2 billion in liquid assets. By Friday, the cash on hand was down to $350 million.

One reason investors in the pool may not be too worried about its cash flow situation, however, is that the county is about to get a tremendous infusion of capital: Property tax bills are due as of Dec. 10. Homeowners are required to forward 50% of their taxes this month. Citron reported in September that full-year receipts total more than $2.1 billion.

County officials have insisted that even though the portfolio’s paper loss now amounts to 20% of the funds clients have invested, there will be little, if any, real loss if investors stay put, allowing the fund’s bonds to mature at full value over the next few years.

Under a worst-case scenario, if cities, school districts and other investors withdraw their money, the resulting losses would hurt municipal coffers across Orange County and could stop road and sewer projects.

Based on Orange County’s experience, the incoming chairman of the Senate Banking Committee said he will conduct hearings on municipal finance.

“Congress and the regulators have already focused attention on derivatives activities due to losses suffered by corporations, investment funds and government entities,” said Sen. Alfonse D’Amato (R-N.Y.). “Today’s loss will most certainly lead to increased scrutiny by . . . Congress.”

In California, Assemblyman Curt Pringle (R-Garden Grove) said he planned to introduce a bill when the Legislature convenes Monday to help thwart such a crisis in the future. Pringle said he began crafting the legislation in June with the help of John Moorlach, the accountant who predicted Orange County’s current problem but was defeated by Citron in the race for treasurer in June.

The measure will propose a series of technical changes in state law to reduce the risks that investment managers can take with taxpayer dollars. It also aims to ensure that local governments have a better idea of the true value of their investments and the risks they are taking.

The four major investors in the pool said Friday they want to review the independent findings of the county’s investment adviser and help plan financial strategy for the future.

The Orange County Transportation Authority, the Transportation Corridor Agencies (which is building the state’s first toll roads), the Orange County Sanitation Districts and the Irvine Ranch Water District have agreed to form a review committee. Together, they have more than $2 billion in the fund.

On Friday, Citron pulled the blinds of his office and worked the phone in an attempt to ease the investors’ fears. His second-in-command met with brokers in Los Angeles.

State Assemblyman Mickey Conroy (R-Orange) and State Sen. John Lewis (R-Orange) have called for Citron’s resignation.

Prices of some Orange County bonds dropped slightly Friday, about $5 per $1,000 face value, amid concerns that county investment losses could harm bond issues. But bond traders and managers of tax-exempt mutual funds said that virtually no Orange County bonds were offered for sale on Friday anyway, on the expectation that no one would buy them.

After the county’s announcement Thursday, large mutual funds and brokers worked to alleviate investors’ fears. Merrill Lynch, which has extended $2 billion in credit to the county for securities purchases, held a telephone conference with more than 30 holders of bonds issued by the county and its cities to assure them that the paper is solid.

Representatives from two credit rating agencies--Moody’s Investors Services and Standard & Poor’s Ratings Group--recently met with Orange County officials and expressed their concerns about the county’s financial stability.

Times staff writers Debora Vrana, Gebe Martinez, Michael Hiltzik, Tom Petruno, Eric Bailey and Ross Kerber contributed to this story.

More on Derivatives: * Reprints of a Times article explaining the complex transactions known as derivatives are available from Times on Demand. Call 808-8463 and press *8630. Select option 1. Order Item No. 2810. $2.95.

What Went Wrong

The Orange County investment fund’s crisis was brought on by the same strategy that enhanced Treasurer-Tax Collector Robert L. Citron’s returns in recent years: the use of borrowed money to bet on falling interest rates.

LEVERAGE: Using loans from brokerages, the fund has borrowed a massive $12.9 billion on top of the $7.7 billion invested by client. Virtually all of the money has been invested in bonds.

RATES TURN: As interest rates have soared this year, the fund’s borrowing costs have jumped while the value of its bonds has tumbled. That has squeezed the fund’s earnings and caused its overall porfolio value to drop.

LOSSES?: So far, the fund’s losses are only on paper. But if it is forced to sell its bonds before they mature, the losses would become real. They would have to be shared by the government agencies whose money the fund manages and, potentially, by taxpayers.

WHAT’S AHEAD: The fund’s challenge now is to pay off its loans as its investments mature. But a further rise in interest rates or demands for cash by its government investors could hamstring efforts to work out the problems.

Fund Performance

For years, Citron’s fund has dramatically outgunned similar government investment pools, including one managed for local agencies by the California Treasurer’s Office. But in recent months, their results have begun to converge.

Sources: Orange County Treasurer; Investment Division, California Treasurer’s Office