Orange County’s Fund Value Falls $1.5 Billion : Finance: Officials seek to calm 180 cities and agencies and prevent run on once high-flying portfolio.

In a financial tremor felt coast to coast, officials disclosed Thursday that Orange County’s investment portfolio--guided by a risky financial strategy--has plunged in value this year by nearly $1.5 billion.

None of the 180 or so cities and other agencies that rely on the county to invest their surplus funds and some pension and other accounts have pulled out of the investment pool, whose complex bond holdings have been hammered by the year’s unexpected rise in interest rates. Indeed, county officials said the largest investors have signaled that they will ride out the current difficulties.

A rush by government agencies to withdraw funds from the pool--worth $18.6 billion after falling 7% in value since January--could force the county to begin selling its holdings, which might accelerate the losses and financially hamstring local government.

“A run on the asset pool will be a death spiral,” said Zane Mann, editor of the California Municipal Bond Advisor in Palm Springs. “It would force the treasurer to sell more (securities) in a bad market.”

The losses in the giant investment portfolio came to light Thursday after rumors swept Wall Street that Orange County was suffering cash-flow problems. By the time county officials held a news conference in midafternoon to deny the rumors, the shock waves had jolted financial markets and raised serious questions about the potential fallout:

* Merrill Lynch, the Wall Street brokerage that has extended Orange County $2.5 billion in credit to purchase securities, promptly denied rumors that it may be exposed to losses as a result of the sharp decline in the county’s holdings. The rumors caused Merrill’s stock to drop $1.50 per share on the New York Stock Exchange, to $36.50.

* County officials announced that they had hired a Wall Street investment adviser to review the portfolio, assess potential damages and make recommendations about how investments might be changed in the future.

* Officials also revealed that cities, school districts and other government agencies--all investors in the pool--met this week with top county officials, who attempted to calm their fears about the plummeting investments. Administrators said it was too soon to say how government budgets would be affected, if at all.

* Major Wall Street credit rating agencies Moody’s Investors Service and Standard & Poor’s, both of which now give Orange County bonds nearly the highest possible rating for safety, plan to meet with county officials next week to analyze the situation. Lower bond ratings would raise the cost of borrowing for the county’s government agencies.

* Assemblyman Mickey Conroy (R-Orange) called on county Treasurer Robert L. Citron, the manager of the county’s investment pool, to either resign or retire.

“It was a bad investment decision with the people’s money,” Conroy said, citing Citron’s extensive use of borrowed money to bet on investment market trends. “He was shooting craps with the people’s money, and the dice rolled wrong.”

The losses incurred by the county fund, one of the nation’s largest, represent a dramatic reversal for Citron. In recent years, the fund’s investment returns have been the envy of the industry, averaging over 9% annually. But critics have objected that Citron, 69, was taking too much risk with public money.

Like many large institutional investors, the county essentially had borrowed money short-term to invest in longer-term bonds, using its clients’ funds as collateral. That strategy worked well while interest rates were declining from 1990 through 1993 and while the difference between short-term and long-term rates was wide. The fund’s profit was basically the “spread” between short and long rates, plus the rise in value of older long-term bonds.

But the tactic has gone awry this year, as interest rates in general have soared with the expanding economy. That has cut the value of long-term bonds issued at lower rates.

Citron, like most money managers, did not see the reversal in interest rates coming. In a report to the County Board of Supervisors in September, 1993, he wrote: “Certainly there is nothing on the horizon that would indicate that we will have rising interest rates for a minimum of three years.”

Because the county used “leverage”--or borrowed funds--extensively, its losses have been magnified, just as its gains were magnified when interest rates were falling. The squeeze has come in part as the securities firms that loaned the money have demanded that the county put aside more cash to “guarantee” the loans.

Overall, the county’s portfolio is leveraged two to three times its value through such transactions as “reverse repurchase agreements,” according to Tanya Styblo Beder, a principal at Capital Market Risk Advisors, the firm that the county has hired to review its portfolio.

Indeed, if the fund’s $1.5 billion in losses were realized, they would represent about 20% of the actual amount, excluding leverage, that government agencies have put into the investment pool--$7.8 billion. For that reason, agencies have been told that if they want their money back now, beyond normal withdrawals, they will be paid 80 cents on the dollar.

Another key problem for the fund is that Citron has invested a significant amount of the borrowed money in securities known as “derivatives”--hybrid investments that often represent a higher-risk bet on the direction of interest rates.

Those securities’ losses, too, can be magnified when interest rates go against the investor’s expectations. Moreover, because of their complexity, derivatives that have tumbled in value have become difficult for some investors to sell at any price.

County officials stressed Thursday that the losses in the portfolio so far are only on paper; most of the securities in question have not been sold, so the losses have not been realized.

“It’s a liquidity problem,” said Matthew Raabe, Orange County’s assistant treasurer-tax collector. “It’s something we need to work through, but it is not a crisis and it is not catastrophic.”

Citron, who remained in the background, made a brief defense of his investment strategies.

“For 15 years I have been managing the portfolio this way,” he said. “What I did was not irresponsible in any manner, shape of form.”

Officials and Wall Street analysts said that as long as the county is not forced to sell securities prematurely at their current depressed prices, it conceivably could ride out the crisis and wait for the investments in question to mature.

This week, Orange County’s chief administrator held two emergency meetings with investors--on Tuesday and Thursday--to request that they not draw higher-than-normal amounts of money from the pool. The investors include every Orange County city except Garden Grove and San Juan Capistrano and every county school district.

“I think that immediately, everyone thought, ‘I wish I could get my money out of here,’ ” said Peer Swan, chairman of the Irvine Ranch Water District, which has $300 million in the investment fund. “But after a while, the general feeling was, we all live in this county and raise our kids here and it’s to everyone’s benefit to hang in here together.”

So far, no investor has requested that its funds be withdrawn from the pool, county officials said. Raabe said the 11 largest investors--including the Orange County Transportation Authority--have agreed to keep their money in the fund.

Although county officials attempted to minimize the impact of the situation, they acknowledged that there could be a severe financial blow to the county and other investors in the county investment pool if participants panic and withdraw their money--or if interest rates continue to rise.

“It does not affect the county employees or the county constituency in any way unless people do not cooperate and we are forced to sell our securities,” said Raabe. “At this point in time, the only danger is that people will decide not to work with us and we will have to sell securities.”

Raabe said the county’s current problem is a lack of cash on hand. If investors decided to withdraw from the investment pool, they would have to get out at current market value and incur some losses, he said.

“The very worst case scenario is that if everybody who is working with us chooses not to, we would have to liquidate the portfolio, and all of the investors would have to share in a $1.5-billion loss,” he said.

There is virtually no risk to the county’s retirement system, Raabe added, because the retirement board has invested only 5% of its money in the portfolio.

County Administrative Officer Ernie Schneider said it appears that the county “will not make as much interest as we had previously anticipated.” The county had planned to collect about $172 million in interest from its investments this year.

Schneider’s counterpart in Los Angeles, Sally Reed, said her county does not face similar problems.

“We do not take these kinds of risks,” she said. “The problem Orange County is finding is they have investments with long-term maturity. They, clearly, have not been as conservative as others.”

Complex derivative investments have been the source of controversy all year, as rising interest rates worldwide have triggered large, unexpected losses for companies such as Procter & Gamble and Gibson Greeting Cards and numerous municipalities. In an extreme case earlier this year, a New York money manager lost $600 million of his clients’ money within 24 hours.

Some regulators worry that the complex and risky nature of the investments could threaten the stability of the nation’s financial system, and there have been calls in Congress to ban derivatives. But the investments are a fundamental part of many investment portfolios, serving in their most benign form as hedges against market fluctuations.

Richard Price, president of FGIC Capital Market Services in New York City, which also manages funds for municipalities, said Orange County officials should have disclosed to investors the day-to-day performance of their portfolio, particularly given the aggressive, high-risk positions it has taken.

“The Orange County pool is one of the most aggressive that’s managed by public officials,” said Price, who appeared with Raabe at a forum sponsored by a trade publication in Santa Monica in September. “As an accounting principle, I do think there’s a matter of disclosure involved here,” he said.

County officials met with Moody’s and Standard & Poor’s in New York two months ago and “received a clean bill of health,” Raabe said. Orange County currently holds an AA rating, one notch below the highest rating possible.

John Moorlach, a certified public accountant who ran against Citron this year, compared Orange County’s financial crisis to that in Cuyahoga County, Ohio, where the county government shut down its investment fund in October under similar circumstances. Moorlach noted that the official in charge of the fund in Ohio had not yet resigned.

The centerpiece of Moorlach’s campaign was his insistence that Citron was taking too much risk with public money.

“This is not a great day,” Moorlach said Thursday. “We are praying for him. This is the worst thing you could go through.”

Chriss Street, a Newport Beach investment banker and well-known critic of Citron’s, said he was dubious about the county’s effort to keep its investors calm. “That’s like saying, ‘The plane is on fire and there are 20 passengers and there are 10 parachutes, so please don’t grab a parachute and jump,’ ” Street said.

Times staff writers Gebe Martinez, Ross Kerber and Rene Lynch in Orange County and Scot J. Paltrow in New York contributed to this story.