ORANGE COUNTY IN BANKRUPTCY : Financial Markets Fear the Crisis Will Have Severe Repercussions

By TOM PETRUNO

Dec. 7, 1994 12 AM PT

TIMES STAFF WRITER

Financial markets are bracing for what could be severe fallout from Orange County’s bankruptcy filing and from Tuesday’s first step in the liquidation of the county’s massive bond portfolio.

Analysts said the scope of the crisis is so broad--encompassing the municipal bond market, the market for U.S. government securities and the mutual fund industry--that it presents a monumental challenge to Wall Street and to federal and state regulators.

“This is going to shake confidence in the entire bond market,” said Richard Lehmann of the Bond Investors Assn. in Miami Lakes, Fla.

“Everybody is in shock,” said one Southland muni bond trader.

Moreover, the solution that markets often look to in times of crisis--for the Federal Reserve Board to quickly ease interest rates, reducing strain on the financial system--is not an option for the central bank because of the economy’s continued strength, experts say.

Indeed, the Fed’s decision to tighten credit this year for the first time since 1989 in effect sowed the seeds of Orange County’s financial disaster by driving all interest rates higher and by narrowing the spread between short- and long-term rates.

Orange County, which has used its $18.5-billion investment fund to bet heavily on lower interest rates, is just the latest big investor to be ruined by the Fed’s turnabout.

But the list of losers has lengthened as the year has progressed, and Wall Street’s great fear is that the county’s unraveling now will prompt new losses for a host of other teetering investors--or bring to light the heretofore hidden portfolio problems of other municipal investment funds.

The only good news for Orange County and for other owners of longer-term bonds is that the bond market has been trying to rally over the past two weeks, pushing long-term interest rates somewhat lower. The yield on 30-year Treasury bonds slid to 7.87% on Tuesday from 7.92% on Monday, and down from 8.13% two weeks ago.

Whether that rally can continue, however, may depend on investors’ response to the Orange County bankruptcy filing and to the potential for a new round of bond liquidations by institutional and individual investors.

Here’s what analysts are most concerned about:

* U.S. government securities. Bonds issued by the Treasury and government agencies such as the Federal Home Loan Mortgage Corp. make up the bulk of securities in the Orange County fund.

If Wall Street begins to fear that the fund will be liquidated--dumping $18.5 billion in securities on the market--other bond investors may attempt to sell ahead of the fund, driving interest rates up again.

Although $18.5 billion in bonds is relatively small given the multitrillion-dollar size of the government bond market, it still is a formidable portfolio to digest, bond pros say.

“If the market perceives there’s a lot more to come, the implication becomes a snowballing effect,” said one major Southland bond investor.

Worse, the county’s bankruptcy comes at a time when many other big investors that had bet on lower interest rates also are throwing in towel, liquidating bonds in the same two- to 10-year maturity range that comprises the bulk of the county fund’s portfolio.

Many of those investors, like the county, had borrowed using short-term loans to buy longer-term bonds. It was a profitable transaction while short-term interest rates remained low in 1993. But in 1994, as short-term rates have moved ever higher, the cost of the loans has come to exceed the yield earned on the longer-term bonds.

Over the past two months the market yield on two-year Treasury notes has soared nearly a full percentage point, to about 7.5% currently, in part because banks and other large investors have bailed out of those securities.

The problem for the U.S. government bond market is that “we don’t know where we are in the (unwinding) process,” said Jim Grant, editor of Grant’s Interest Rate Observer newsletter in New York. “The banks have been trying to get out in front of the problem, but we don’t know how much more short-term stuff is left to be sold.”

Although brokerage CS First Boston was able to unload $2 billion of Orange County’s bonds in a surprise sale late Tuesday, analysts said the market’s ability to digest those came before investors fully understood where they were coming from, or that the county’s bankruptcy was imminent.

Of particular concern nationwide is whether other municipal investment funds, like the Orange County fund, have waited until now to acknowledge their bond market losses and troubles with complex “derivative” securities.

“It makes the market now wonder who else that we don’t know about has one foot in bankruptcy,” Lehmann said.

* Municipal bonds. Wall Street is terrified that the county’s bankruptcy, which had not been considered even a remote possibility as recently as last weekend, will so stun institutional and individual investors that many will seek to bail out of any and all muni bonds--even those far afield from Orange County and California.

Although most analysts say that wholesale dumping of muni bonds would be illogical--because most municipal bond issuers are certain to come out of this crisis without any financial difficulties--that is unlikely to stop some fearful investors from selling.

The muni bond market, like the U.S. Treasury bond market, had been rallying in recent weeks, pushing yields lower. But some analysts said Tuesday that the rally could end for now, especially in California muni bond issues.

The mutual fund industry is especially concerned. Because the funds have become such important players in the muni bond market over the past five years, a slew of redemptions by fund shareholders could quickly slam the muni market and the funds, because portfolio managers may find there are few other big investors on which to unload bonds.

Mutual funds that own any Orange County bonds or related securities fear that they are particularly vulnerable to selling--even if they own a relatively minuscule amount of the county’s paper, and even if their bonds are covered by private insurance or other enhancements that will guarantee that interest payments are made.

“Just about everybody owns some of it,” said one mutual fund manager, referring to Orange County debt. And the managers stuck with a public relations problem could include those managing short-term funds, such as muni money market funds, as well as those managing longer-term funds.

But if investors sell out of munis and perhaps out of longer-term U.S. government bonds, where would they put their money?

Many Wall Streeters expect a “flight to quality”--meaning that investors will rush into very short-term U.S. Treasury securities, such as three- and six-month T-bills. That could drive down yields on those securities. But many economists say that would not affect the Federal Reserve Board’s stance on credit.

The best the markets can hope for, experts say, is that the Fed will decide against any additional increases in short-term rates until the current crisis blows over.

But Philip Barach, a bond portfolio manager at Trust Co. of the West in Los Angeles, sounded a hopeful note late Tuesday, noting that peaks in interest rates often occur around financial crises.

“This is usually when you see a market turn,” Barach said, recalling the Latin American debt crisis in the early 1980s and the stock market crash in 1987.

Piling Up Debt

America’s local governments have piled up more than $1.2 trillion in debt, an increase of more than 250% over the last 15 years. Orange County’s financial crisis has raised doubts about the safety of municipal debt and the integrity of public finance.

MUNICIPAL DEBT OUTSTANDING

In billions of dollars:

1980: 365

1994: 1,218*

MUNICIPAL DEBT HELD, BY SECTOR

In billions of dollars*: Households: 410

Mutual funds: 220

Property, casualty insurance: 152

Personal trusts, in banks: 118

Money market funds: 111

Commercial banks: 99

Closed-end mutual funds: 45