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Today, Orange County...

Wall Street's municipal bond dealers aren't known for panicking easily. But on Dec. 6, they did.

Five days earlier, California's Orange County had announced that its investment fund of $7.4 billion faced losses of $1.5 billion, the result of a confluence of sharply higher interest rates and an investment strategy that relied primarily on derivatives and enormous leverage. The problem, in a nutshell: County Treasurer Robert L. Citron borrowed $14 billion, investing the money in interest-sensitive derivatives contracts, hoping to increase returns for his fund. When rates turned up, Orange County was forced to pay more on its borrowings than it was earning on its investments.