Orange County Looks at Cause as Cure for Fund

To begin repairing its loss-ridden investment portfolio, Orange County may have to turn to new versions of the same transactions that helped create the fund’s massive problems, officials say--complex “derivative” securities.

But that possibility, one of many options the county’s financial advisers are considering to stem portfolio losses that now total $1.5 billion, could be a hard sell with fund investors who may fear digging a deeper hole for themselves, both financially and politically.

Top Orange County administrators convened in secret Saturday night to assess the damage caused by Thursday’s disclosure that the fund had suffered a financial jolt from which it may take years to recover.

In another development, officials revealed that four Orange County school agencies last year took the extraordinary step of borrowing $200 million for the sole purpose of reaping profits from the county’s controversial investment portfolio. They received a special guarantee against risk, but the sharp decline in the value of the county’s investment fund makes prospects for the venture unclear.

The fund’s reversals, amounting to a 20% principal loss, shocked financial markets last week and sparked new calls from Sacramento to Washington for tighter controls on public investing.

Indeed, in the wake of large losses incurred by numerous investors in derivatives this year, the market for those often-misunderstood securities has been under heated attack by regulators and politicians, many of whom are seeking to ban certain transactions or sharply limit their use.

In that context, new derivative purchases by the Orange County fund--even if aimed at protecting against greater turmoil--may not sit well with the fund’s municipal investors or with Orange County taxpayers.

“Just the mention of derivatives at this point makes people uneasy,” said Allan Roeder, city manager for Costa Mesa, which has $2.6 million in the fund.

“We would be very cautious about the use of more derivatives,” said Lisa Mills, assistant chief executive officer for the Orange County Transportation Authority, which at about $1 billion is the pool’s biggest investor. “I think we would have to examine any proposal (from the fund) very carefully.”

Among the investors are 31 school districts and agencies in Orange County that borrowed an estimated $550 million to invest in the fund. About $350 million of this amount is money that school districts routinely borrow to cover operating expenses while they await expected tax revenues.

But four of the agencies--Newport-Mesa Unified School District, Irvine Unified School District, North Orange County Community College District and the Orange County Department of Education--took the extraordinary step of borrowing an additional $200 million solely to invest in the fund.

Provided with written and oral promises in 1993 that the county’s huge investment fund would safeguard their investments, the four agencies hoped to earn about $1 million a year each from the deal.

If the return from the county’s investments drops too far, the agencies could have trouble paying the interest on their loans. And if other investors pull out of the county investment pool, some school officials are worried that Treasurer-Tax Collector Robert L. Citron may not be able to follow through on his guarantee to protect the borrowed $200 million.

Unlike other investors in the county pool, the districts can withdraw their funds only in June.

“This is the most secure of the whole issue,” said John L. Nelson, assistant superintendent of business services at the county Department of Education. “The regular pool, we’re all aware, there’s no guarantee to it.

“As of now, I still feel comfortable (that the districts’ investment is secure),” he added, “but I don’t have all the answers yet. And I don’t think I will for a few days.”

Two investors warned Saturday that they might withdraw from the investment pool, a step that could unravel any financial recovery plan for the fund.

The chairman of the Irvine Ranch Water District said he was so frustrated in October with his inability to get answers from Citron that he ordered $100 million withdrawn last month.

District Chairman Peer Swan said Saturday his board has notified the county that it will pull out its remaining $300 million if it cannot be part of a proposed advisory board that top investors want to create to oversee the county’s future dealings.

The mayor of Newport Beach also expressed concern about the portfolio, suggesting publicly that the city pull its $16 million out of the fund.

Still, Swan said the prospect of a new derivative-type investment as a mechanism for solving the fund’s crisis did not trouble him.

“If the only solution is to use derivatives to alleviate any pain and suffering, I’d approve it so fast it’d make your head spin,” said Swan, whose district is the fourth- largest investor of the 70 agencies that voluntarily have their money in the pool. “I’m going to do what I think business-wise is best. We need to protect our principal.”

Citron, an elected official who has held the treasurer post for 24 years, said Saturday that the county had ordered him not to discuss the situation.

Ironically, given all of the anguish caused by Citron’s use of complicated derivative securities in the $18.5-billion fund, Wall Street financiers say the global derivatives market may now offer the best hope for quickly abrogating the fund’s ill-fated and heavily leveraged bet on falling interest rates.

The dramatic expansion of the derivatives market in recent years means “there are new ways to get into trouble, (but) there also are many new ways to get out of trouble,” said Tanya Styblo Beder, a principal at New York-based Capital Market Risk Advisors, which the county has hired to review the fund.

In particular, experts say, the fund could use derivatives known as “interest-rate swaps” to effectively “immunize” itself from further increases in interest rates, which have cut the value of the portfolio’s long-term bonds this year.

Derivative securities, as the name implies, are hybrid investments or transactions whose terms or returns are derived from price changes in other securities (such as conventional stocks and bonds) or from movements in market interest rates. Thus, they offer a way to either bet on changes in the market or hedge against such changes.

The $8 billion in derivative bonds owned by the Orange County fund are mostly “inverse floaters”--in effect, high octane bets on falling interest rates. The bonds’ yields rise if market rates decline.

Conversely, if market rates rise--as has happened this year, with a series of increases engineered by the Federal Reserve Board to slow the national economy--inverse-floater bonds’ yields automatically fall.

In addition to those bonds, the county’s fund owns more than $10 billion in conventional fixed-rate bonds, some maturing as far in the future as 1999. While the yields on those bonds don’t change, the bonds still have lost value as yields on new bonds have surged this year.

Compounding the fund’s problems is its huge debt load. Confident that interest rates would fall, Citron borrowed $12.9 billion via short-term loans to buy the bulk of the fund’s longer-term bonds.

Thus, the fund is suffering a double whammy: As short-term interest rates continue to rise, the cost of the loans is increasing, while the inverse-floater bonds’ yields are falling and the value of all of the bonds in the portfolio is eroding.

One solution, many Wall Streeters say, is an interest-rate swap, a fairly common derivative transaction. With a swap, the fund would essentially “lay off” the risk of further interest rate hikes on another investor or number of investors, thereby halting the squeeze between the fund’s debt costs and the return on its portfolio.

A swap “is one of the options we’re looking at,” Matt Raabe, assistant county treasurer, confirmed Saturday. “The idea would be to protect the fund against further market-value erosion.”

That could give the fund more breathing room, potentially saving it from putting up more of its diminished cash balances as collateral against its loans.

Raabe disclosed Saturday that collateral calls had cut the county’s cash reserves to $350 million from between $1.3 billion and $1.5 billion at the end of August.

But experts caution that a swap would be no panacea. For one, it could be an expensive transaction, further depressing the fund’s shrinking returns.

Second, “if the fund locks out all the interest-rate risk, it will be locked into the current situation,” said Robert W. Kolb, a University of Miami business professor and expert on financial derivatives.

That situation--high short-term borrowing costs and dwindled returns on the fund’s longer-term bonds--could guarantee minuscule yields on the portfolio for years, as the fund waited for its bonds to mature to pay off the loans.

Raabe conceded that “returns on the fund possibly could be very low” for an extended period. That would be the reverse of the fund’s performance in recent years, when it routinely yielded much more than competing funds.

Those results won Citron accolades--and, perhaps, conditioned his government-agency investors to expect relatively high interest income.

If many of the fund’s municipal investors prove unwilling to sit still for poor returns--and so demand their money back--they could force the fund to sell its devalued bonds on the market, turning what now is a 20% paper loss into a real loss.

But officials from some of the cities and districts that have invested in the pool said Saturday they would go along with a new derivatives-based workout plan, even if it depressed their earnings from the fund, if that was the only way to protect their principal in the long run.

“We’d have to take some heat,” said Michael Ward, mayor of Irvine, which has $190 million invested in the county pool, about $25 million of which is city workers’ pension money. “But our first priority is to protect our principal. It’s a big guess, and it’s a lot of money to guess with.”

Other participants were more cautious.

Using new derivatives “reminds me of when I’m in Las Vegas and I’m losing so I switch to a different table,” said Robert D. Breton, a former mayor who last week retired from the City Council of Mission Viejo, which has about $18 million, mostly bond proceeds, in the county pool. “The City Council will have to take a close look at this.”

Within the army of Wall Street professionals now searching for ways to end the county fund’s crisis, some said Saturday that the gigantic size of the fund may be more a blessing than a curse in arriving at a fast--and workable--solution.

“We just don’t want a panic,” said one financier who asked not to be named. “The best minds in the business are working on this one now.”

Times staff writers Mark Platte, Matt Lait, Jodi Wilgoren and Chris Woodyard in Orange County contributed to this story.