ORANGE COUNTY IN BANKRUPTCY : Some Experts Say County May Have to Liquidate Fund : Finance: Among options discussed to salvage troubled portfolio are deep discounts or a complicated derivatives swap.
It seems increasingly likely that Orange County will eventually be forced to restructure and possibly liquidate all or most of its huge bond portfolio, either through deep discounts or some type of complicated swap, experts said Thursday.
“Everyone knows this stuff is going to have to hit the street sooner or later,” said Steven Clarke, a former director of fixed-income investments at Goldman Sachs & Co. in Los Angeles, who was called in to help the city of San Jose sell parts of its $325-million bond portfolio when it got into similar trouble a decade ago.
“It’s a question of what the restructured bonds will look like and who will buy it,” he said.
Orange County, which on Tuesday filed the largest government bankruptcy in U.S. history, said Thursday it has assembled a financial team led by former state Treasurer Thomas Hayes to guide the county out of its crisis, but details about their strategy to salvage the portfolio were not released.
“They can continue business as normal under Chapter 9 bankruptcy and they can start to liquidate or restructure the portfolio,” said Ron Rus, a bankruptcy lawyer in Newport Beach. “But to me, it’s frightening. The problem here is that the portfolio is so highly leveraged that there is not a sufficient asset there. Somebody or a group of somebodies are going to have to take a (big loss).”
One of the wealthiest areas in the state, Orange County ran into trouble when former Treasurer-Tax Collector Robert L. Citron, who resigned under fire earlier this week, used a risky investment strategy to leverage county money in a massive bet on bonds--a bet, in essence, on falling interest rates.
Instead of focusing on portfolio safety and liquidity, Citron concentrated on rate of return as a measure of success.
The highly leveraged pool--valued at $20 billion at its peak--included only $7.5 billion in county and municipality funds, while more than $12 billion had been borrowed. The county said last week it has lost $1.5 billion on the portfolio since Jan. 1, but some analysts say those losses have grown this week as major investment banking firms such as CS First Boston and Morgan Stanley have sold off--at discounted prices--most of the bonds previously bought on credit.
In the early 1980s, the city of San Jose also was lured by high yields, investing heavily via reverse repurchase agreements, following the advice of Wall Street brokerages to borrow short-term funds to buy long-term bonds.
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In a scenario similar to Orange County’s, the high-risk reverse repo transactions began to lose money as interest rates rose in 1983. But unlike in Orange County, San Jose city officials caught the problem early, acting quickly to sell off $106 million in bonds, allowing it to raise enough money to pay its debts. The city’s losses were confined to $60 million.
Orange County will probably attempt to solve its problems through some sort of a portfolio restructuring, though the bankruptcy adds a new spin.
“Now that they are bankrupt, you have a whole new ballgame,” said Clarke, who advised San Jose. “You have two ways you can go: You can continue to manage the portfolio, or you can restructure and sell it. As long as they hold the securities, they are exposed to further interest rate risks.”
Although the bond market in recent days has absorbed $9 billion in U.S. government agency bonds sold by the fund’s brokerage lenders as they liquidated their collateral, it’s unclear how much some of the more complicated “derivative” bonds left in the portfolio would fetch if sold. The derivative securities’ yields generally decline as market rates move up.
Orange County is looking for help from Capital Market Risk Advisors Inc. in New York, a company that typically advises banks, mutual funds and large corporations on how to avoid or control losses from derivatives.
“Once a loss is posted, you can’t really do anything,” said Leslie Lynn Rahl, principal of the firm. “You can put out a new (derivative) bet and hope it will do better.”
Although Rahl would not elaborate, one of the options reportedly being considered by Orange County is another risky transaction--some type of derivatives swap arrangement that would hedge Orange County’s previous bets that interest rates would decline.
“One of the solutions to a derivative that’s underwater is that you buy something else” to balance the risk, said Zane Mann, publisher of the California Municipal Bond Advisor in Palm Springs. “Then you have to find some way to sell it or wait until it matures to prevent future losses.
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But turning to additional investments in derivatives--the same type of transactions that led to the county’s current troubles--could be unacceptable to the more than 185 local agencies whose investments in the county’s pool are effectively frozen.
County administrators said they filed bankruptcy to avoid a run on the fund and to give them some time to enlist expert help.
“I think they are going to use some time to sort it through in a rational, thoughtful way,” said Barbara Shipnuck, former chair of the National Assn. of Counties Tax-Exempt Finance Committee.
