NEWS ANALYSIS : Challenge for Fund Advisers: Avoid Fire Sale

By TOM PETRUNO and MICHAEL A. HILTZIK

Dec. 14, 1994 12 AM PT

TIMES STAFF WRITERS

Buyers can be found for the complex bonds remaining in Orange County’s doomed investment fund, but the challenge for the fund’s advisers is to avoid a fire sale--and in the meantime keep the securities’ value from diminishing further.

Accomplishing all of that in the take-no-prisoners world of today’s financial markets will be crucial to limiting the fund investors’ loss to what is now 27 cents on each dollar they put in, the fund’s advisers conceded Tuesday.

On Wall Street, reaction to the workout proposal unveiled by the county’s adviser, the Salomon Bros. brokerage, was generally positive. But experts warned that any number of variables could upset the plan--including another potential interest rate hike when the Federal Reserve Board meets next week.

Salomon and fund overseer Thomas W. Hayes, the former California state treasurer, made clear Tuesday that they intend to rid the portfolio of the high-risk, long-term bonds that were central to the fund’s ill-fated bet on falling interest rates.

Yet they left open the question of exactly how quickly they will proceed, except for setting a six-month deadline.

Hayes pledged that “we are not going to do a fire sale” with the remaining securities.

But wringing the best possible prices from potential buyers will be tough, many analysts say, because the sophisticated investor audience for the complex securities is relatively limited.

In a surprise to some experts, Salomon estimated that the fund’s “structured note” derivatives--hybrid bonds that make up 60% of the remaining portfolio--have lost only 10.1% of their market value this year. The conventional bonds constituting the rest of the portfolio are down 4.4% in value, according to Salomon’s estimates.

Structured notes are designed to produce varying rates of return depending on the movements of interest rates or the prices of other securities.

Overall, Salomon said the fund’s portfolio now is worth $5.4 billion, after subtracting loans still outstanding to a handful of lenders. That figure represents a 27% loss to the fund’s investors, based on the $7.4 billion the county now says the investors put in.

The size of the investors’ loss has been magnified by the fund’s heavy use of borrowed money to balloon its wrong-way bet on interest rates.

Late Tuesday, some derivatives experts who have studied the county fund’s holdings expressed surprise at Salomon’s estimate of the remaining bonds’ market value. Some of the fund’s structured notes have dropped more than 20% this year, these analysts said.

Many of the structured notes in the fund are designed to pay lower interest rates as market interest rates rise, as has occurred over the past 12 months. Thus, their value declines sharply with each rate increase.

One Wall Street derivatives expert went so far as to call Salomon’s price tag on the fund “ludicrous,” though he could not give a reason why Salomon would overestimate the portfolio’s value. If the brokerage has been overly optimistic, the municipalities in the fund may build up false hopes for limiting their ultimate losses.

Salomon’s market value estimate also is important because it indicates the price level at which Salomon expects to begin receiving bids for the bonds. At the same time, it gives potential buyers an idea of how much negotiating room they may have.

Some Wall Street traders said Salomon is warning them against submitting low-ball bids for the bonds. Still, many were skeptical that Salomon can avoid adding to the fund’s huge losses as it liquidates the securities, especially if the liquidation is rapid.

“They’re telling us they’re going to sell in a ‘controlled’ fashion, but define that,” said one mutual fund manager contacted by Salomon. “Their first goal is to get rid of it.”

Unlike conventional fixed-rate bonds, structured notes and other derivatives are attractive to a limited audience of investors because of the relative difficulty in putting a daily price tag on them and in understanding their risk.

“I don’t think you’re going to see much bidding on these,” said Zahid Ullah, principal at Gotham Derivatives Inc. in New York. And by definition, a smaller pool of bidders will mean that pricing negotiations will be tougher than if all the securities were conventional bonds.

Wall Street brokerages themselves--Salomon excluded--will probably be the principal bidders for the derivatives, analysts say.

Yet the participation of certain big brokerages may be in doubt. A number of major firms are at risk of being sued by the county for calling in loans to the fund last week, precipitating the bankruptcy filing. The county has sued Nomura Securities and has pledged to file suit against the other major brokerages that redeemed its collateral.

Whether those same firms now would stand up as buyers for the rest of the fund’s securities is not clear.

Hayes and William D. Rifkin, the chief Salomon adviser on the fund, indicated that they expect some insurance companies and mutual funds to be buyers of the remaining bonds. But many of those investors are under no pressure to buy unless they can strike sweet deals, analysts say.

“We would be interested,” said Art Steinmetz, manager of the Oppenheimer Strategic Income bond mutual fund in New York. “But we’re interested only if we can get this stuff at distressed levels--if it’s cheap enough,” meaning that the bonds’ prices would have to be set low enough to offer the buyers extremely attractive returns.

Rifkin said another option for the fund is to attempt a restructuring of some of its bonds with the original issuers, mainly government agencies such as the Federal Home Loan Bank System, the Federal National Mortgage Assn. and the Student Loan Marketing Assn.

The attraction in returning to those issuers to essentially “unwind” the derivatives’ structures is that it might be less costly for the fund than selling the securities to other investors, analysts say.

But the agencies would be unlikely to offer the fund a bailout of any kind; they would only restructure the bonds if it meant no change in their own financing situation and costs.

Spokespersons for all three of the agencies said Tuesday that they either are having discussions with the fund’s representatives or anticipate having them.

At a minimum, many analysts expect the fund to turn to at least one more set of derivative transactions before being liquidated--some sort of interest rate swap that would hedge at least a portion of the portfolio against any further increases in market interest rates.

A swap would effectively freeze much of the fund’s losses where they currently stand, though such a transaction also would keep the fund from enjoying any benefit of a sudden decline in market interest rates.

Some Wall Street experts say that rather than sell the remaining bonds in a short time period, the smarter strategy would be to hold the securities and dispose of them over a longer period--while hedging away the interest rate risk inherent in them via a swap.

“The first thing we’d tell them (the county) is, ‘Don’t sell,’ ” said Ullah.

But with many Orange County municipalities in need of cash and eager to extricate themselves from the debacle--and also eager to excise the derivatives stigma from their shrunken portfolio--Ullah and other analysts concede that a fast liquidation of the bonds might be the most politically expedient approach.

Wall Street sources also say a speedy dissolution would probably be preferred by Salomon because of the potential fees that could be generated for a relatively brief investment of time by the firm.

NEWS ANALYSIS : Challenge for Fund Advisers: Avoid Fire Sale

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