O.C. IN BANKRUPTCY : Salomon, Merrill and Mexico Smoothed Fund’s Liquidation

Despite dire warnings in mid-December that Orange County’s bankrupt investment pool was in ever-increasing peril, the county’s financial advisers said this week that they have successfully liquidated virtually the entire portfolio--and earned more than expected.

So where does the credit go for that feat, accomplished in a mere six weeks?

In part, Wall Streeters agree that Salomon Bros., the fund’s adviser, was impressive in executing its liquidation strategy, which involved marketing billions of dollars in diverse bonds on the open market or back to the government agencies that issued them.

But Salomon had help, and from some unlikely sources--Mexico, for one, and Merrill Lynch & Co., now the county’s nemesis because of its former financial adviser role.

Here’s a look at how the portfolio was disbanded with such speed, and for $36 million more than what was viewed as an optimistic price target set by Salomon six weeks ago:

* The market backdrop changed. When Salomon estimated on Dec. 12 that the market value of the bonds owned by the county (after subtracting loans owed) was $5.03 billion, the caveat was that any additional rise in interest rates would slash that figure dramatically--by $300 million for each one-percentage-point rate increase.

The flip side, however, was that a decline in market rates would cause the fund’s bonds to appreciate in value.

Fortuitously for Salomon and the county, the general trend in rates since mid-December has been down, especially for bonds in the three- to 10-year maturity range, which is what the county owned a lot of.

The three-year Treasury note yield, for example, has slid from 7.80% on Dec. 13 to 7.63% now. That means investors have been willing to pay higher prices for Orange County’s bonds--and accept lower yields--than they would have in mid-December.

Bond yields have declined because Wall Street increasingly believes that the Federal Reserve Board won’t push short-term interest rates up much further. Despite a still-robust economy, bond investors collectively seem convinced that only one or two additional Fed rate hikes will be needed to finally slow economic growth. That, in turn, may allow long-term bond yields to ease or at least stabilize after rocketing in 1994.

“The tone of the bond market has changed” since mid-December, says James Midanek, a principal at Solon Asset Management in Walnut Creek, Calif. “People are thinking that the next Fed rate hike (expected on Jan. 31) may be the last one.”

That thinking may turn out to be dead wrong--but it’s been a blessing for Orange County.

* The calendar changed. Last year was horrendous for all investors stuck holding long-term bonds in a rising rate environment--Orange County just got hit worse than most. But come Jan. 1 each year, many investors effectively wipe the slate clean and look for moneymaking opportunities rather than dwell on past losses. Pension funds and other big investors often get fresh cash from clients in early January, providing the fuel with which to make new bets.

As sentiment in the bond market has shifted and investors have become more willing to buy, prices firmed up for some of the most volatile bonds in Orange County’s fund--the so-called structured notes.

In particular, the fund’s inverse-floater notes, which pay less interest if market rates rise but more if rates fall, may have attracted more investor attention thanks to the bond market’s turnabout. “If rates stabilize or come down, those notes begin to look like winners again,” noted one Wall Street bond dealer.

That’s especially true for certain notes whose interest payments will be “stepped up” this spring, meaning they will automatically increase unless short-term market rates rise sharply.

* A “flight to quality” occurred. The Mexican financial crisis that exploded with the peso’s devaluation on Dec. 20 caused some U.S. investors to flee Latin American stock and bond markets for safer securities. And “safer” usually means U.S. government or government agency bills, notes and bonds, like those that were owned by Orange County’s fund.

What’s more, the Mexican crisis heightened speculation that the Fed won’t tighten credit severely from here, to avoid exacerbating Mexico’s debt troubles. (Higher U.S. interest rates would automatically mean higher rates in Mexico.) That speculation has helped put downward pressure on bond yields.

* Merrill Lynch bought heavily. In Bankruptcy Court papers filed Tuesday, Merrill revealed that it has bid for many of the Orange County fund’s bonds as they’ve been put on the market since Dec. 15. “In many of the transactions, Merrill Lynch was the successful high bidder, and Merrill Lynch’s presence supported the high price received by the pool,” the firm said.

Salomon wouldn’t comment on Merrill’s purchases, but other bond dealers confirmed that Merrill frequently outbid every other interested investor.

Why would Merrill “help” Orange County in this way, given that the county is suing the brokerage for $2.4 billion, alleging that Merrill orchestrated the fund’s downfall by abetting former Treasurer Robert L. Citron’s ill-fated strategy of borrowing short-term to buy long-term bonds?

One theory is that Merrill hopes to use its purchases as evidence of its continuing support for the county in any upcoming trial, even after being painted as the villain. Perhaps more important, Merrill may be trying to forestall legal problems with other clients who purchased structured notes and other exotic securities from the brokerage in 1993 and ’94 and who now are seething about losses on those securities.

“Merrill may be trying to say to those clients, ‘See, the bonds we sold you are not a problem. . . . We’ll show you that by buying them back ourselves,’ ” said a veteran bond fund manager.

A Merrill spokesman wouldn’t comment on the firm’s motives or put a figure on Merrill’s purchases. But he confirmed Merrill “bid actively . . . particularly for securities we had sold” the county originally.

Yet even in assisting the fund’s liquidation, Merrill risks criticism: If it has kept the bonds for itself, and market interest rates fall, Merrill will reap a gain from securities that the county had to sell at a loss, albeit a slightly smaller loss than originally anticipated.