ORANGE COUNTY IN BANKRUPTCY : County, School Districts Get Fannie Mae Funds : Ruling: Judge Ryan turns over $118.5 million that the mortgage lender withheld from a repurchase of volatile securities. The money will help schools repay creditors.

U.S. Bankruptcy Judge John E. Ryan has turned over $118.5 million to Orange County and four education districts, rejecting a claim by the Federal National Mortgage Assn. that has kept the funds frozen in an escrow account for months.

The money will be used to replenish county accounts and pay school debts.

Under Ryan’s ruling, which became available Monday, Newport-Mesa Unified School District, North Orange County Community College District, Irvine Unified School District and the Orange County Board of Education will get a total of $28.5 million. Another $90 million will go to the county.

Marc Winthrop, an attorney representing three of the education districts, said the schools hope to use their share to help repay about $200 million in debt due June 13.

“We’re very pleased with the ruling,” Winthrop said. “This money is important to help maintain the schools’ credit rating. We need to maintain access to the capital market to finance school operations.”

The county’s portion goes into dozens of accounts for now, said bankruptcy attorney Lee Bogdanoff. The eventual fate of the funds will be settled in negotiations with creditors, Bogdanoff said.

“The important thing is that this puts back funds that were never pledged to Fannie Mae and makes them available,” Bogdanoff said. “We now have $90 million more than we did before Judge Ryan ruled.”

Fannie Mae spokesman David Jeffers said the mortgage lender is still reviewing Ryan’s ruling and may decide to appeal.

The disputed funds, the subject of numerous court motions and a hearing earlier this month, were part of the proceeds from Fannie Mae’s December repurchase of $634 million worth of securities from the Orange County Investment Pool.

After the sale, Fannie Mae tried to keep $118.5 million to offset debts that the county and schools owe the agency, payable this summer. Fannie Mae and county officials finally agreed to set the money aside in an escrow account and deal with the issue later.

Fannie Mae attorneys argued that given the county’s bankruptcy and $1.7 billion in total losses in the investment pool, Fannie Mae has good reason to worry that the schools and county might default on their debts.

But in his written opinion, Ryan called the attempt by Fannie Mae to keep the $118.5 million in proceeds “unfair, inappropriate and inequitable.”

Ryan ruled that the investment pool is a separate entity from the county and schools. It would therefore be illegal for the mortgage lender to try to keep money from one entity to pay off debts owed to it by others. “If I allow this, 190 [investment pool] participants will bear the county and school districts’ debts,” he wrote.

Ryan’s ruling means the mortgage lender will have to get in line with other note holders for payment, Bogdanoff said. But Jeffers warned that Fannie Mae expects its money.

“I would stress that the underlying obligation still stands,” Jeffers said. “We fully expect to be paid.”

Bogdanoff said the county will ask creditors, including Fannie Mae, for a yearlong extension to repay its $1 billion in short-term debt. The school districts want a 90-day extension at most.

The $634 million worth of Fannie Mae notes that the investment pool sold back to the mortgage lender in December were among the riskiest Orange County had bought for its disastrous portfolio. They included some of the portfolio’s more elaborately structured “inverse floaters,” securities designed to pay higher yields as market interest rates fall.

But as interest rates last year rose sharply, the dividend payouts on the securities plummeted. To prevent further losses, the county sold them back to the agency and replaced them with more stable securities.

The county attributes more than $600 million of its total pool losses to the unstable securities Fannie Mae had sold to the county.