Orange County Stumbles In Risky Business Plan

County's highly leveraged investment fund takes dive

RESIDENTS of this seaside community are asking themselves what America's largest-ever government bankruptcy case means for life in one of the nation's wealthiest counties.

``Are police, firemen, teachers going to get laid off?'' asks Dennis Friedrich, who for 15 years has resided at the corner of Tustin and 17th. ``What about road projects, the new [Rams/Angels] stadium, Disneyland's expansion?''

As dust settles from the major economic temblor that hit here this week - the filing by Orange County officials for protection from creditors demanding repayment of $1.2 billion in loans - shock waves continue to reverberate statewide and beyond.

The key question is how one of the US's largest, richest, and most conservative counties allowed its $7.5 billion investment fund to plummet 20 percent in value through unorthodox investment procedures. But as details unfold and a Securities and Exchange Commission investigation looms, the episode spotlights other key issues as well.

In these budget-strapped times, what other government entities are engaging in similar or even more risky practices? How can the same pressures or traps be avoided elsewhere? Will lessons learned be translated into new safeguards?

``From all I can tell, the practices that resulted in the Orange County [bankruptcy filing] case are not widespread,'' says Larry Naake, executive director of the National Association of Counties (NAC) in Washington. Mr. Naake holds that several factors were unique - among them a mix of voluntary and ``mandated investments'' from a raft of investors, including 170 school districts, cities, and county units. And he says specific errors by the fund's manager and in management oversight make it hard to generalize.

Strategy on the rise

But others say similar practices have put government entities into financial liability in Ohio, Texas, Florida, Maine, Minnesota, and Maryland.

``I think there are lots of losses out there and they have been coming due all year long,'' said Federal Reserve Chairman Alan Greenspan to a congressional committee Wednesday. One congressman called for new regulations on the process. SEC Commissioner Richard Roberts says he believes the list of local governments, colleges, and pension funds using complex and risky investment options such as derivatives and repurchase agreements are on the rise, surmising ``there [are] more [bankruptcies] coming.''

Analysts attribute concern over other municipal funds as one factor in tumbling stock and bond prices on Wall Street this week.

``There is a concern that municipal bonds will be dumped by individuals, setting off another decline in the market,'' says Arnold Kaufman, editor of Standard & Poor's investment newsletter, ``Outlook.''

The Orange County crisis developed when it became known that the county's $7.5-billion investment pool had lost $1.5 billion - about 20 percent of its stake - because of a highly leveraged and risky investment strategy used by County Treasurer Robert L. Citron. The strategy, which depended on low, short-term interest loan rates, had been used for several years. But it proved disastrous this year as rates were ratcheted upward by the Federal Reserve.

Mr. Citron had pledged investors' securities as collateral to buy $20 billion of high-quality bonds issued by US government-sponsored agencies through a leveraged short-term financing arrangement known as ``repurchase'' agreements. At the time, these bonds were paying relatively high rates of interest. As interest rates continued to rise, the short-term loans could only be renewed at higher and higher rates, and the value of the long-term bonds began to decline.

Into Chapter 9

A group of banks this week declined to roll over or renew $1.2 billion of existing ``reverse-repurchase'' agreements. Because the figure was more than the fund could raise without selling securities whose value had been depressed, the county filed for protection under a rare provision in the US Bankruptcy Code known as Chapter 9.

The procedure gives county officials 120 days to come up with a strategy to pay the fund's debts. Analysts say the provision does not mean the county is out of money, will necessarily default on bond payments, or is even in bad economic shape.

``When we look at Orange County over the long term, we see it to be very strong financially in terms of tax base, utility, and enterprise funds,'' says Paul Williams, vice president for municipal securities at John Nuveen & Co.

Local officials say that police, fire, and other services will continue uninterrupted, but others question that assessment if bankruptcy proceedings become drawn out. In either case, the county's bond ratings have already been downgraded. This means that the cost of borrowing for public needs will become more costly, which in turn raises the prospect of new taxes.

``This will fuel more skepticism of bond use in the government sector,'' says Joel Kotkin, senior fellow for the Center for the New West in Denver. ``You are going to see a shift [by local governments] of funding to pay-as-you-go rather than borrowing against the future.''

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