‘Less Risky’ Pool May Have Lost More : Portfolio: Fund paying lower interest was supposed to be safe, but its losses may exceed 27% overall rate, analysts discover. Investors are ‘dumbfounded.’

The 13 Orange County agencies and cities that invested in a “safe” investment pool managed by former county Treasurer Robert L. Citron may have lost a greater percentage of their money than those participating in the county’s supposedly riskier--and higher-yielding--investment fund, county financial adviser Thomas Hayes said Thursday.

Hayes and financial analysts from the Salomon Bros. investment firm have found that the so-called bond pool, which was supposed to be a low-risk, low-yield, short-term depository for working funds, invested in risky “derivative” securities and borrowed money to make further investments, just as did the larger “commingled pool.”

Its losses may match or exceed the 27% suffered by the county’s $7.8-billion portfolio as a whole, Hayes said. The bond pool accounted for $1.27 billion on Nov. 30.

Through his attorney, Citron denied doing anything improper.

Hayes, who was appointed a special financial adviser after the county filed for bankruptcy protection Dec. 6, made his remarks in an interview just before giving the Orange County Board of Supervisors his latest interim report on the condition of the crippled investment portfolio.

Overall, he said, although the sale of $3.3 billion in portfolio holdings by Salomon Bros. had succeeded in sharply curtailing the portfolio’s riskiness, it is still highly exposed to losses from increases in prevailing interest rates.

So far, the ultimate investment loss suffered by the pool still appears to be fixed at his Dec. 13 estimate of $2.02 billion. “It’s still very risky, it still has derivatives, and it’s still leveraged,” he said. “But it’s less leveraged and less risky than one week ago.”

Hayes said that the county might soon be turning its attention to whether it needs to return to the capital markets for new loans or help in restructuring its debt.

Salomon Bros. has asked several Wall Street firms to propose how they might underwrite a new issue of Orange County debt securities if the county tries to raise fresh cash from investors. The firms, which included such leading underwriters of municipal debt as Goldman, Sachs & Co., Lehman Bros. and Morgan Stanley & Co., were asked to respond to Hayes by Tuesday.

Hayes said no specific type or dollar amount of offering was being considered but he wanted to screen potential underwriters now so that their services would be available as needed. “It’s another arrow in our quiver,” he said.

But he warned that given the bankruptcy and the county’s default on existing debt, a return to the credit markets “is going to be a very difficult situation.”

“We’re not even close” to estimating what the cost to the county might be of floating a new debt issue, he said.

As for the so-called “bond pool” and “commingled pool,” the distinction has become an issue in Bankruptcy Court and elsewhere as the 13 investors in the smaller bond pool contend that they should shoulder a lesser loss than the 187 municipalities and agencies in the larger fund.

Among other things, they argue that Citron and his assistant, Matthew Raabe, implied that they were receiving a lower rate of return on their money because they tolerated less risk in their money.

But Hayes said Thursday that he has seen no evidence that the investments in the two pools differed in nature.

“The contention that there were only ‘safe’ investments in the bond pool is not borne out by the records that are available,” he said.

Hayes said he could not explain why Citron paid a lower rate of interest to the smaller pool’s investors. “The accountants are looking at where the money went,” he said.

For their part, treasurers of some of the agencies with money in the bond pool expressed outrage Thursday at learning that their funds were invested so imprudently.

“I’m just dumbfounded,” said Orange County Transportation Authority Finance Director James Kenan, whose agency was the largest investor in the bond pool, with $560 million.

“No one in their right mind would leverage a pool where there’s no demand for yield and it’s short-term duration,” he said. “A short-term pool you have to be able to snap your fingers and get out. These derivatives, by definition, you can’t get out. That’s just suicide.”

“Those of us in the bond pool assumed that it was in safer, lower-risk investments and that’s why we were getting a lower rate of return,” said Vicki Baker, finance director of Yorba Linda, which had $6.5 million in the pool. “Now I’m sitting here thinking: ‘Gee, we’re going to take the same loss as the commingled and we got less interest?’ That makes it even worse. You think that you’ve heard the worst through this whole thing, and every day there’s something new.”

But she and other officials said they never obtained written assurances from Citron or Raabe that the money would be specially handled.

“I remember saying, ‘Do you have anything in writing?’ ” she said. “And they’d say no. And I remember thinking they never really got their paperwork act together. Now it all makes sense.”

The extent to which Citron and Raabe laid out the riskiness of the pool’s investments could also become an issue in federal civil and criminal investigations, experts say.

If the treasurer’s office failed to reveal to the 13 investors in the “bond pool” that their money was also highly leveraged or invested in exotic securities, then criminal and civil statutes on disclosure may have been violated, said former Securities and Exchange Commission enforcement official Sam Gruenbaum, now a Los Angeles securities lawyer.

“If you’re telling investors in the bond pool everything’s safe . . . but you don’t tell them that it’s leveraged two times, that would be a material fact that the investor should know about,” he said.

Asked whether Citron may have misled investors into believing the bond pool was invested conventionally, David Wiechert, Citron’s attorney, said investors should have known the bond pool was leveraged and tied up in derivatives. That’s because, although it earned less interest than the county’s commingled fund, it earned more than the state’s conservatively run investment pool, he said.

“Mr. Citron didn’t intend to defraud anyone with regard to the two funds,” he said. “Bob never made it a secret from anybody how he was trying to make his money.”

According to Hayes, exotic derivatives--largely U.S. agency notes whose interest payout and value decline as prevailing rates rise--now comprise nearly 80% of the remaining portfolio, compared to 60% as recently as Dec. 13. The ratio has risen because the investment advisers have focused on selling off the most easily marketable securities, mostly conventional bonds and notes, in order to raise cash quickly.

Hayes said those moves have succeeded in raising the county’s cash balance by more than $1.8 billion, while paying off $1.53 billion in loans.

Remaining in the portfolio is $5.45 billion in face value of securities, including $4.04 billion in derivatives. The county also l owes about $1.62 billion on loans taken out to make investments.

At the same time, the potential loss to the portfolio from a one-percentage-point rise in interest rates is now $220 million, down from $300 million on Dec. 13. Much of that improvement is the result of a reduction in the average maturity of the county’s holdings, down from four years at the time of the bankruptcy filing to somewhere between two and three years now, Hayes said.

He added that the $1.8 billion in cash raised by the portfolio liquidation was reinvested in U.S. treasury securities with maturities of less than 30 days, a choice dictated by the need to respond to possible court orders that may require the county to quickly make large payouts to investors, county agencies and municipalities.

Times staff writers Jeff Brazil in Orange County and James F. Peltz in Los Angeles contributed to this story.