NEWS ANALYSIS : Legal Experts Foresee Epic Battle With Wall Street : Finance: Losses from sale of collateral could be devastating. Brokerages insist they were within rights.
Wall Street’s rush to cash in $9 billion worth of collateral on loans to tapped-out Orange County has set up an unprecedented battle between one of the nation’s most affluent counties and some of the most powerful brokerage houses.
Legal experts say the clash over the sales--and the county’s bankruptcy filing itself--make for a legal tangle that may take years to unwind. Adding to the difficulty is the lack of legal precedent, since there has never been a municipal bankruptcy this large or complex.
“This will be without a doubt an epic case in the history of insolvencies,” declared Hugh Ray, a Houston lawyer who chairs the American Bar Assn.’s business bankruptcy committee. “There are kids running around in Orange County in junior high today who will be joining this case once they get through law school.”
Wall Street is worried that it will be painted as a villain because of the collateral sales. But the brokerages maintain that they are within their legal rights and that, far from kicking the county when it’s down, they did their best to forestall the crisis.
“Look, nobody’s a bad guy here,” one brokerage official said.
In three days, with surprising ease, seven big brokerages unloaded nearly $9 billion worth of U.S. government agency bonds that the county had pledged as collateral under the complex financial transactions--known as reverse repurchase agreements--it was using for short-term borrowing.
The only holdout in the selling spree is Merrill Lynch, which holds $2 billion of Orange County collateral and repeated Thursday that it has no intention of selling. Merrill Lynch, whose central role as a financier to the county’s investment fund is coming under close scrutiny, may be trying to salvage its public position by giving the county some breathing room.
The total worth of the fund reached about $20 billion at its zenith: $7.5 billion in money from 180 municipalities and $12.5 billion in borrowings from Wall Street brokerages.
As has become dismally clear in the last week, former Treasurer-Tax Collector Robert L. Citron was using the loans to buy other bonds--including risky and devilishly complex derivatives--in an effort to boost returns on the county’s investment fund.
The aggressive strategy blew up as interest rates turned against the county, producing losses--on paper--that the county put at $1.5 billion as of last week. But that figure now appears suspect.
Traders and other Wall Street sources say that the brokerages have been pressing for and receiving more collateral in recent months as interest rates rose and the bonds declined in value. As more collateral was turned over, it effectively eroded the $7.5 billion in principal invested by the municipalities. That erosion turned into real losses when the collateral was sold, but the county Thursday refused to provide a new estimate of total losses.
As the fund’s position deteriorated, “we tried to get (county finance officials) to deal with the issue,” said an official of a major brokerage who spoke on condition of anonymity. “We worked with them and worked with them, and one day, they didn’t return our phone calls. Next thing you know, they filed for bankruptcy.”
The county’s filing Tuesday night under Chapter 9 of the U.S. Bankruptcy Code was precipitated by CS First Boston’s sale earlier that day of $2.6 billion of the county’s collateral.
According to traders and brokerage officials, the other brokerages that sold collateral Wednesday and Thursday, and the amounts involved, are as follows: Morgan Stanley, $1.6 billion; Kidder Peabody, $1 billion; Prudential Securities, $900 million to $1 billion; Nomura Securities, $900 million; Smith Barney, $800 million, and PaineWebber, $650 million.
Chapter 9 contains an “automatic stay” that forbids creditors from enforcing their claims against a municipality under bankruptcy protection. The county believes that provision should have put a freeze on the collateral and prevented the sales.
The county Thursday authorized its lawyers to sue brokerage houses that it believes violated the stay, but experts say Wall Street has some legal weight on its side.
In the early 1980s, after several government securities trading firms defaulted on repurchase agreements and went bankrupt, the Federal Reserve joined the securities industry in pressing Congress to make sure that the collateral involved in such transactions would not get frozen in bankruptcies. The rationale was that “repos” are part of the grease that keeps the financial markets running and they need to be kept risk-free or brokerages will shy away from them.
Ray, the Houston attorney, says that Chapter 9 contains language that appears to exempt repurchase agreements from the stay. And Congress in 1984 emphatically exempted repos from the automatic stay in Chapter 11, which deals with corporate bankruptcies. Why didn’t Congress include that more specific exemption in Chapter 9?
It was an oversight, Ray said, which probably occurred because “nobody ever contemplated that a municipality would be involved in the banking and brokerage business.”
Which raises another question: Will the Orange County investment fund--which filed under Chapter 9 separately from the county itself--be able to qualify as a municipality? Ray doesn’t think so.
Herbert Katz, a Santa Monica attorney and former chief judge of the U.S. Bankruptcy Court for the Southern District of California, said: “The magnitude of the Orange County case is just incredible.” Previous Chapter 9 filings have generally involved small towns, water districts and other special-purpose municipalities that ran into hard times or got hit with huge liability judgments, he said.
Therefore, there are few precedents for some of the issues raised in the Orange County case. “Any time the law is unsettled, the judge has more flexibility to fashion his own remedies,” Katz added.
The brokerages Thursday generally declined to discuss their legal positions other than to reiterate that they think the sales were exempt from the stay.
As brokerages put the billions of dollars in collateral bonds on the market Thursday, traders said the securities were sold with relative ease.
But because of the glut of bonds sold in the two- to five-year maturity range, the brokerages offered enticing yields on many of the securities to assure that there would be takers, traders said.
Most of the bonds, U.S. government agency securities, were sold at yields that were 0.15 to 0.20 percentage points higher than they would have been early in the week, said portfolio managers who looked at the bonds.
Michael Kennedy, manager of the SteinRoe Government Income bond fund in Chicago, said he bought some of the collateral bonds as brokerages put them on the market. The securities he bought mature in 3 1/2 years and yield 8.2% annualized.
“They’re (brokerages) sort of pricing them on a worst-case basis” to assure that the securities are sold, Kennedy said. While good for the market, he said, “That’s not good for the county,” which effectively loses as the securities are marked down further in price to boost their yields.
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How Wall Street Took Control
Here is an explanation of the process by which major Wall Street brokerages lent money to Orange County’s investment fund, and how those firms this week have called in those loans.
Brokerage firm Z lends the county $1 billion in cash, and takes $1 billion in government securities owned by the county as collateral.
As interest rates rise and the value of the bonds declines in the market, the brokerage demands that the county put up additional bonds to guarantee the loan. This is a “collateral call.”
This week, in the wake of the county’s bankruptcy and its failure to make regular loan payments, the brokerage exercises its right to seize the government securities it holds as collateral, and sell them.
If the securities held are worth the full $1 billion amount of the loan when sold, the brokerage doesn’t experience a loss. If the securities are worth less than $1 billion when sold, the brokerage must accept the loss--and become a general creditor of the county fund to recover the rest owed.
For the county, the collateral calls by brokerages in recent months mean that the county’s fund has been drawn down by an as yet undisclosed amount from the $7.5 billion the original investors put in--resulting in a loss to those investors.
Wall Street’s Exposure
Estimated amount of securities held by big Wall Street firms as collateral against repurchase agreements with Orange County. All the firms except Merrill Lynch have sold the collateral this week.
Firm Amount (billion) CS First Boston $2.60 Merrill Lynch $2.00 Morgan Stanley $1.60 Kidder Peabody $1.00 Prudential Securities $0.90-1.00 Nomura Securites $0.90 Smith Barney $0.80 PaineWebber $0.65
Source: Brokerage and securities traders
