Risky Investment Takes $1.5-Billion Bite Out of O.C. : Finance: Officials seek to calm 180 cities and agencies and prevent a run on county’s 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-Tax Collector 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 more than 9% annually. But critics have objected that Citron 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, it 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.

House Banking Committee Chairman Henry B. Gonzalez, a Texas Democrat who has crusaded for more control of derivatives, suggested the fund managers were “just plain gambling. They just thought they could beat the house.”

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 or 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.

“Before people start to criticize they better look at the overall benefit that they’ve received as well,” said Anaheim City Manager James D. Ruth. “Citron has done an awful lot of good for a great deal of cities, including Anaheim. He’s done a great job of managing that pool through some very difficult times.”

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.

Mike Stamenson, a fixed-income salesman for Merrill Lynch in San Francisco, is the broker with whom Orange County officials worked to develop their derivative investments. He declined to comment Thursday about the dropping value of the portfolio.

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 M.W. Moorlach, a certified public accountant who ran against Citron this year and was defeated, 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.

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.

A Different Kind of Tremor

A nearly $1.5-billion drop in the value of Orange County’s investment fund forced officials to publicly discuss the losses Thursday.

The Aftershock

Brokerage firm Merrill Lynch saw its stock price fall $1.50 on rumors that it lost money, but officials denied it.

County leaders called for calm and hired an investment adviser to assess the damage and recommend changes.

Major investors in the $18.6-billion fund expressed concern, but said they have no plans to withdraw money.

Investment Terminology

Here are some of the terms used by investors and brokers as they structure sophisticated financial deals:

* Derivatives: Complicated options or futures deals whose value is based on an underlying stock, bond, commodity or index. “Exchange-traded” derivatives are offered for sale on regulated exchanges, which theoretically guarantee that buyers and sellers can always be found. “Over the counter” derivatives--those at issue in the Orange County controversy--are designed by banks and brokerages and tailored to the needs of sophisticated customers. But because they may be unusual or even unique, there is no easy way to set a value on them.

* Call option: A contract allowing, but not requiring, the holder to buy a given commodity at a set price (the “strike price”) by a certain date. If the strike price is higher than the cash price of the commodity at the expiration date, no sale takes place, and the option expires. If the strike price is lower than the cash price, the owner of the option exercises the right to buy the commodity. It can then be sold immediately at the higher price.

* Put option: A contract allowing, but not requiring, the holder to sell a given commodity at a set price (the “strike price”) by a certain date. If the strike price is lower than the cash price of the commodity at the expiration date, no sale takes place, and the option expires. If the strike price is higher than the cash price, the owner first buys the commodity at the lower market price, then immediately exercises the right to sell it at the strike price. The difference is the profit.

* Futures: Contracts obligating the buyer to purchase a given commodity from another party on a certain date. Among other things, the underlying commodity can be grains, other foodstuffs, oil, bonds, stocks, or baskets of stocks that make up a stock index. Most futures are traded on regulated exchanges in Chicago and New York. In most cases, delivery of the underlying commodity never takes place; the deal is closed by the sale of an equivalent future.

* Cap: A feature of a derivative that allows a user to set a ceiling on a risk. For example, a company may want a cap that protects it from paying interest on its debt above a certain level.

* Floor: The opposite of a cap. A user might be seeking protection from the effects of interest rates falling below a certain level.

* Structured notes: Investments designed to pay a given return if interest rates remain within a certain range. If rates go higher or lower than the range, the notes pay no interest and thus drop in value.

Source: Times reports

Merrill Lynch Slides

Merrill Lynch & Co.’s stock fell $1.50 a share Thursday on rumors that the brokerage suffered large losses related to Orange County’s investment portfolio. Hourly stock prices:

Wednesday close: $38.00

Thursday open: $37.63

Thursday close: $36.50

Source: Bloomberg Business News; Researched by HOPE HAMASHIGE / For The Times

The Players

Here are some of the main figures in the drama surrounding the county’s investment portfolio:

* Robert L. Citron: County treasurer-tax collector manages county investment portfolio, known for his aggressive investment approach. He defended his practices as sound.

* Matthew Raabe: Assistant treasurer-tax collector who was the main spokesman in explaining the county’s investment strategy during a news conference Thursday. He downplayed the impact of “paper losses” and said there is no crisis.

* John M.W. Moorlach: Costa Mesa accountant and Republican Party activist; ran against Citron in last election and criticized investment strategy

as too risky; called for investigation into county’s portfolio last June.

* Ernie Schneider: County administrative officer and caretaker of the county’s funds; said it is too soon to determine how the lost interest revenues will affect county services and employees in the long run.

* Chriss Street: Newport Beach investment banker was an outspoken critic of Citron’s fund management long before the county’s financial portfolio became a campaign issue. Attempted to persuade the Newport-Mesa Unified School District to withdraw its funds.

Source: Times reports

MISERY HAS COMPANY

Orange County is the biggest loser yet, but dozens of cities, counties and school districts across the country have taken big hits on derivatives. A22

WHO’LL FEEL PAIN

How the “paper loss” might translate into reality for local cities and agencies, bond issues and other county investments and financial plans. A23

EXPLAINING THE ARCANE

Answers to the most common questions about derivatives, starting with “What are they?” A23

ADVICE FOR INVESTORS

The state municipal bond market will be grim in coming days, writes columnist Tom Petruno, but damage isn’t likely to be permanent. D1