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.

With the county's supervisors meeting privately in a Santa Ana municipal building, rumors of bankruptcy were rampant. Wall Street investment banks had billions in loans outstanding to the county. Yet the affluent California municipality was stonewalling demands for information. Frustrated and worried, at least one firm appealed to the governor of California and the Federal Reserve Board to intervene.

Quickly, the crisis played itself out. First, Orange County missed a $200 million payment on $2.6 billion in reverse repurchase agreements, a form of securitized loans, to First Boston Corp. With the county close to default, First Boston immediately liquidated its entire holdings of Orange County collateral, made up primarily of government bonds.

"SCARED TO DEATH." At 5 p.m. California time, the county supervisors hoisted the white flag. Facing the prospect of further liquidations and pressure from agencies clamoring to recover their investments in the fund, Orange County and its fund filed for Chapter 9 protection from bankruptcy in Santa Ana Federal Court. Suddenly, up to a dozen firms, among them Merrill Lynch, Morgan Stanley, and Nomura Securities International, were stuck holding billions in loans that Orange County would not honor. It still isn't clear whether those firms are prohibited from liquidating their collateral in the wake of the filing. "People are scared to death," says one Wall Street executive. "No one wants to be last to get their money."

Orange County's stunning bankruptcy filing, the largest ever in the municipal world, cast a chill over U.S. markets--driven partly by investor worries about other portfolio losses. On Dec. 7, prices in the $1.2 trillion municipal bond market sank more than a full point--a huge drop in that market. Treasuries took a hit as well, pushing the yield on 30-year bonds up to 7.89%. Even stocks were hurt, with the Dow Jones industrial average declining 10.43, led by financial companies, including brokerages that lent money to Orange County.

The shock waves from the Orange County disaster will be felt for months. In the short term, other California counties may find it tough to raise funds; already, trading in California and other muni bonds has dried up, says Joan Payden, who runs Payden & Rygel, a Los Angeles bond firm.

SCRUTINY. The meltdown also could invite an era of far more intense regulation in both the municipal and derivatives markets--both of which, until now, have largely avoided Washington's gaze. "What is being ducked here by everyone is accountability," says Representative Jim Leach (R-Iowa), the incoming chairman of the House Banking Committee. Leach promises to reintroduce a bill requiring the Securities & Exchange Commission to establish accounting and other standards for all derivatives investors.

Across the U.S., rising rates have stung others as well. On Dec. 7, Texas acknowledged losses of $70 million from repurchase agreements and reverse repos in a state investment pool. And San Diego County and the Florida State treasurer said they have racked up a combined total of $550 million in paper losses brought on by interest-rate hikes. From Charles County, Md., to Cuyahoga County, Ohio, local officials who have used leverage and dabbled in exotic interest-rate derivatives to boost returns have been caught short (table). "Perhaps because the returns were so good, there was not enough attention to risk," says Dennis J. Roche, a consultant to Cuyahoga County.

There likely are many more blowups in the making. But no one knows just how many problems are out there. That's because municipalities' investments are subject to far less stringent rules than mutual funds and other investments. Federal regulations are few, and municipal funds aren't required to price their holdings daily, as are private investors such as pension fund managers. Says Robert B. Lamb, professor of finance at New York University's Stern School of Business and an adviser to many municipalities: "You will not see losses until they declare them. They are hidden, buried. As they wait for rates to turn around, they make it worse. Some of these people are out of their depth."

Back in Orange County, lawyers and regulators are sharpening their claws. Many of the 187 school districts, transportation authorities, and cities that invested in the fund already are mulling suits. The most likely targets: the Wall Street firms that lent Orange County money. The agencies expect "securities firms to shoulder some of the responsibility," says Haig Nargesian, senior analyst at Moody's Investors Service. Regulators also are probing the fund. The Commodity Futures Trading Commission has announced an investigation. And the SEC wants to know if Orange County was using the proceeds of bond issues to invest in derivatives--and, if so, whether proper disclosures were made about such financing.

The SEC also may ask whether Merrill, which underwrote a $600 million note for the county earlier this year, informed investors where the money was going. "Something is amiss when the system can tolerate this kind of situation," says one SEC official. Says a Merrill spokesman: "We believe that we have conducted ourselves in a totally ethical and proper manner in our dealings with Orange County."

Meanwhile, Orange County citizens face a loss of interest income and, probably, a delay in repayment of principal. Ultimately, the county's towns and agencies may have to make up the fund's losses, either in the form of reduced services or higher taxes. The county itself expected to earn $150 million in interest in 1995 to help fund its $3.7 billion annual budget. That money just disappeared. Says Peter Whittingham, the executive assistant to Gaddi Vasquez, one of five county supervisors: "This will have an effect upon county services and delivery of services." Financing costs could rise sharply, as well.

Despite the magnitude of Orange County's losses, the fund's risky investment strategy should be no surprise, either to investors or to voters. John Moorlach, the Costa Mesa accountant who challenged Citron's reelection this past spring, made a major campaign issue of the investment strategy. "There was no exit plan," says Moorlach, who lost decisively. "If you want to make a killing, you've got to be prepared to be killed. But when you do it with my tax dollars, the question is: Why were you able to do that?" On Dec. 6, investors, regulators, and Wall Street started asking the very same question.

         Public entities with recent large investment losses
         ORANGE COUNTY, CALIF. Its $7.4 billion fund lost $1.5 billion on derivatives 
      and reverse repos when the bond market collapsed.
         CHARLES COUNTY, MD. Lost $8.3 million in mid-1994 by investing 98% of its 
      assets in collateralized mortgage obligations and structured notes. The county 
      sued 12 brokerage firms for losses.
         CUYAHOGA COUNTY, OHIO's highly leveraged $1.8 billion fund lost $137 million 
      when bond prices fell. A local prosecutor is investigating eight securities 
      firms and two banks.
         ODESSA COLLEGE The Texas school lost $7 million in mid-1994 after investing 
      $22 million in collateralized mortgage obligations. It issued new debt to cover 
      the loss.
         WEST VIRGINIA Morgan Stanley is still fighting a $48 million court award 
      stemming from the state's $279 million loss in 1986 and 1987 on Treasuries, 
      reverse repos, and options.
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