Where There Are Losers, There Are Winners

Orange County’s doomed investment fund will probably end up being liquidated in its entirety over the next few weeks, ending one chapter in what will undoubtedly be a long saga.

And while the fund’s final losses should be in the neighborhood of $2 billion--a mere drop in the bucket in the many-trillion-dollar global financial system--this crisis has, of course, already reverberated far beyond the borders of Orange County.

But where there are big losers in an investment debacle, by definition there should also be big winners. Tough as it may be for Orange Countians to swallow, their pain has indeed been others’ gain.

Here’s a tally of some of the major winners and losers so far in O.C.’s Fundgate:

* Winner: Investors who took a contrarian stance on interest rates in 1994. Former Orange County Treasurer Bob Citron ruined his once-$20-billion fund by continuing to load it up with long-term bonds this year, betting that market interest rates would fall again.

Instead, rates have rocketed far higher than almost anyone on Wall Street anticipated a year ago, as the economy has boomed. So the smart investors were those who began to build up their cash reserves early in the year, and continued to do so all along--despite the chorus of “experts” predicting lower rates.

Now, as the O.C. fund is liquidated, the investors buying the fund’s discounted bonds are locking in 8%-plus annualized yields, in some cases double the yield Citron was earning on the securities.

That is where the fund’s $2-billion loss went: It’s essentially a wealth transfer to investors who were savvy enough to wait for better returns on bonds.

* Loser: Municipal investment funds everywhere. Most local treasurers won’t necessarily lose money on their current investments, but they’ll all be hurt in the long run if state or local lawmakers force such funds to limit their portfolios to plain-vanilla, no-risk securities.

To be sure, Citron’s strategy of borrowing massively short-term to buy long-term bonds and brain-scrambling “derivatives” was absurd. But what has been forgotten is that Citron’s excesses were late in the game; from 1990 through 1993, his bet on falling interest rates was correct, highly profitable and seemingly well-managed.

Point is, there’s no excuse for taking public money to Las Vegas. But if lawmakers now force municipal investment funds to bail out of anything that isn’t risk-free, the funds’ returns will be condemned to the cellar--and needlessly.

Remember what happened when many public pension funds dumped their high-yield “junk” bonds in 1990? They sold at the market bottom, missing out on the three-year rally that followed.

* Loser: The mutual fund industry. The fund industry should have been a beneficiary of Orange County’s mess. After all, many owners of individual municipal bonds issued by the county’s entities are probably now wishing they had invested in a diversified muni fund instead.

But because many muni funds themselves owned Orange County-issued bonds--even though in very small quantities, for the most part--fund investors have been spooked.

Longer-term bond mutual funds, which have been suffering shareholder redemptions all year, saw another $1 billion flow out (industrywide) in the week ended Wednesday, according to figures compiled by AMG Data Services in Arcata, Calif.

And short-term California muni money market funds alone lost nearly 7% of their assets last week, AMG says--even though most fund parent companies assured money-fund shareholders that they wouldn’t lose a penny, because the parents will spend their own cash to buy out questionable Orange County-issued debt held by the funds.

That makes the funds two-time losers in this debacle: More shareholders are cashing out, and the parent companies are stuck picking up the tab for any defaults on Orange County bonds they own.

Make that three-time losers--because fund companies risk long-range trouble by continuing to send shareholders the message that they will be protected from credit-related losses.

* Winner: Salomon Bros. By most accounts, the Wall Street brokerage has done a slick job so far in launching the county fund’s liquidation, which Salomon was picked to handle in part because most other major brokerages had been lenders to the over-leveraged fund.

Although many Wall Streeters scoffed last week when Salomon said it believed it could get 73 cents on the dollar for the doomed fund’s bond holdings, the sale of $1.49 billion in securities on Thursday and Friday garnered prices that were surprisingly high.

A Salomon executive said Friday that the entire batch of securities sold Thursday and Friday brought prices “consistent with or slightly ahead of” the firm’s recovery estimate made last Monday.

“Salomon was very organized,” one Wall Street bond trader remarked on Friday.

Though the firm’s biggest challenge lies ahead--unloading the derivative bonds that make up the bulk of the county’s portfolio--Salomon has already cemented its image as a “white knight” in this crisis, which can’t but help its business worldwide.

* Loser: Merrill Lynch & Co. The nation’s biggest brokerage (by most measures) is trying hard to spin-control its way out of this mess, but it’s not succeeding.

Not only did Merrill abet Bob Citron’s borrowing to buy longer-term bonds, it also sold him many of those bonds. Rumors flew last week that Merrill had offered to buy the entire portfolio back from the fund--at a market price, of course--if the county would agree not to sue.

Merrill has declined to comment officially on any purchase offer it may have made, but the possibility of Salomon’s selling the whole enchilada to Merrill seemed ridiculous from the start: Why would Salomon let Merrill walk away a seeming hero when Merrill surely would only buy the portfolio if it could make money selling the pieces for more than it paid?

* Winner and loser: The U.S. government agencies that issued most of the bonds owned by the fund. By allowing Wall Street to fashion their securities into high-risk derivative bonds--high risk to the un-hedged buyer, that is--agencies such as the Federal Home Loan Bank System and the Student Loan Marketing Assn. saved 0.10 to 0.15 percentage points in interest versus what they’d pay to issue less complicated debt.

For agencies that need to raise tens of billions of dollars each year to fulfill their congressionally mandated duties, such as funding federal student loans, that apparent small savings in interest costs means a lot.

While the agencies can argue they were only doing their jobs--trying to secure the lowest-cost funding available--they are being made into villains by critics who believe that investment pros like Citron were somehow snookered into buying agency derivatives.

Moreover, some critics erroneously believe that Citron’s loss on a specific type of derivative--agency bonds that are designed to pay less in interest as market rates go up--is the agencies’ direct gain. In fact, the derivatives are structured so that the agencies’ funding costs are fixed; they didn’t take the other side of Citron’s bet. Instead, that risk was “swapped” to other investors, mainly major banks.

Even so, the agencies are working with Salomon on transactions that could result in an agency-sponsored “unwinding” of the county fund’s derivatives. Such transactions wouldn’t bail out the fund, but they could save it a small amount of money versus selling the bonds on Wall Street.

The risk to the agencies is that other investors with similar derivative problems could form a long line in back of Orange County, demanding that they, too, be unwound from bond bets they may now claim they didn’t understand.

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