O.C. Fund Plunge Draws Increasing Concern, Scrutiny : Crisis: County treasury officials still reeling from $1.5-billion loss. Investors, Congress, federal regulators and Wall Street move to tighten oversight on investment pool.

Orange County’s financial crisis drew mounting concern and scrutiny Friday from top investors, congressmen, federal regulators and a Wall Street credit agency as they assessed the full implications of a stunning $1.5-billion plunge in the value of the county’s investment fund.

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 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 funds in the kind of exotic financial investments that now afflict Orange County.

* An Orange County assemblyman declared that he will introduce legislation in Sacramento on Monday to outlaw the risky investment strategy 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 bonds sold 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 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 and fielded dozens of calls from anxious investors.

“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 F. Dixon, the city manager of Orange, who determined when he took the job in March that the city had too much money in the fund. He pulled $7 million of Orange’s $31-million investment out of the fund.

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 use of “derivatives”--investments that typically involve complex bets on the direction of interest rates. Like many large institutions, the county essentially borrowed money short-term to invest in longer-term bonds, using its participating agencies’ funds as collateral.

That strategy earned big returns of up to 10% a year while interest rates were declining and the difference between short-term and long-term rates was wide. But the tactic has backfired on the county in a period of rising interest rates. Investors in the county pool learned this week that if they wanted to withdraw money, they could do so only at a 20% loss.

A measure of how dire Orange County’s situation has become is reflected in how much cash it has lost in just the past month. By 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 might not be too worried about its cash-flow situation, however, is that the county is about to get a tremendous infusion of capital: Payments on property-tax bills are due as of next Saturday.

Although it’s unclear exactly how much in taxes will be paid, 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.

National financial experts question whether investors had a clear understanding of what Orange County’s treasurer was doing 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, city treasurer of St. Petersburg, Fla. “The lack of understanding had always bothered me.”

Under a worst-case scenario, if cities, school districts and other agencies 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 finances.

U.S. Sen. Alfonse D’Amato (R-N.Y.). called Orange County’s plunge “by far the biggest loss to date” in investments in such securities.

“Congress and the regulators have already focused attention on derivatives activities due to losses suffered by corporations, investment funds and government entities,” he said. “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 M.W. Moorlach, the accountant who predicted Orange County’s current problem but was defeated by Citron in the race for treasurer in the June primary.

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.

“I think it’s important to encourage more prudent investing,” Pringle said. “You don’t necessarily need to take the greatest risk with taxpayers’ dollars. This occurred because people were trying to stretch the public’s dollars farther. But you can’t keep betting against those odds and win.”

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.

“I want to see what is being done now and want to feel comfortable with it,” said Peer Swan, chairman of the Irvine Ranch Water District. “I think a lot of smaller investors depend on us doing this.”

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 personally with brokers in Los Angeles.

“He’s trying to deal with the situation,” Schneider said. “Things are pretty crazy right now.”

Not only is Citron--county government’s only elected Democrat--struggling to save the county’s financial future, but he is also trying to save his job. Some Republican leaders smell blood.

“It’s no coincidence that the one Democrat who holds elected office in Orange County is the one who screws it up for the rest of us,” said Rep. Dana Rohrabacher (R-Huntington Beach).

Schneider said county officials, including the Board of Supervisors, continue to support Citron, who this year faced his only challenger in 24 years. “But I don’t want to make any predictions about the future,” Schneider said.

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

“Based on what I know right now, it sounds like he has been rather reckless and irresponsible in his investment patterns,” Lewis said. “Unless there’s a very good defense of this, I think that (resignation) would be the best thing to do.”

At the national level, the losses were proving to be an embarrassment for Orange County. Louis Rukeyser, host of the “Wall Street Week” television program, quipped Friday that the financial crisis “has John Wayne spinning in his airport.”

Among investors holding Orange County bonds, there were few signs of panic selling.

Prices of Orange County bonds dropped slightly, about $5 for every $1,000 of value, on concerns that county investment losses could harm bond issues. Bond traders and managers of tax-exempt mutual funds said that virtually no Orange County bonds were offered for sale on Friday, 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 on Friday. 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 to express their concerns about the county’s financial stability. Moody’s said it was looking at the “pool’s ability to meet its ongoing liquidity needs” and what might happen should losses occur.

Standard & Poor’s said that while it has no indication that Orange County has a problem with its liquid assets, the agency put Orange County bond issues on negative notice, an action that usually precedes a credit rating downgrade.

Contributing to today’s coverage of the investment turmoil in Orange County were: Times staff writers Eric Bailey, Greg Hernandez, Michael A. Hiltzik, Ross Kerber, Sheila Kern, Matt Lait, Gebe Martinez, John O’Dell, James Peltz, Tom Petruno, Mark Platte and Debora Vrana; and correspondents Jeff Bean, Bill Billiter, Debra Cano, Bert Eljera, Alan Eyerly, Danielle A. Fouquette, Hope Hamashige, Russ Loar, Frank Messina, Jon Nalick, Holly J. Wagner and Lesley Wright.

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.

Sorting out the Mess

A risky investment strategy has thrown Orange County’s once high-flying investment fund for local government agencies into turmoil. The fund’s challenge: to keep agencies from pulling out, which would force fire sales of securities and balloon Orange County’s losses.

REVERSE REPOS: HEART OF THE PROBLEM

Orange County used financial instruments called reverse repurchase agreements to borrow against its $7.5 billion in investment holdings, leveraging the fund up to more than $20 billion. Here’s how reverse repos work:

1. The owner of a security--a $1-million, five-year Treasury note with a 6% coupon, for example--pledges the note to an investment bank as collateral for a $1-million loan.

2. The investor then uses the loan to purchase another $1-million, five-year note earning 6%.

3. Assume the investor is being charged for the loan at an annual rate of 4%. If interest rates remain stable, then his yield on his $1 million--originally only 6%--is now 8%: 6% plus 6%, minus 4%.

4. Here’s the risk: The investor is borrowing short-term; reverse repo transactions generally have a term of 30, 60, or 90 days, at which point they are routinely rolled over. But the investor is using the money to buy long-term investments. If interest rates shoot up, as they have this year, he gets squeezed twice:

A. The value of his collateral--the original $1-million note--drops, so his lender demands cash or more securities to make up the difference. Since August, Orange County has had to add $650 million in collateral with rising interest rates.

B. The rate charged by the bank on the loan rises as the loan is rolled over. If rates rise quickly enough, the cost of the loan may rise above the return on the investment.

MAN ON THE SPOT

Robert L. Citron’s performance as Orange County treasurer-tax collector has come under fire with the disclosure of substantial reversal’s in the county’s investment fund. Some background on Citron:

* Age: 69

* Residence: Santa Ana

* Salary: $100,339 a year.

* First elected: Won election as Orange County tax collectro in 1970. Became treasurer in 1973 when the Board of Supervisors combined the positions.

* Politics: The only Democrat holding elective office in Orange County government. Ran unopposed between 1970 and 1994.

* ’94 Challenge: John Moorlach, a certified public accountant and financial planner, ran against Citron, criticizing his management of county funds as too risky. Citron won with 61.1% of the vote in the June 7 election.

Sources: Orange treasurer-tax collector; Times reports

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