by Jim Impoco; Mike Tharp; David Hage; Linda Grant
An old travel guide published by the California Office of Tourism describes Orange County this way: "It's the most California- looking of all the Californias, the most like the movies, the most like the stories, the most like the dream .... The temperature today will be in the low 80s. There is a slight offshore breeze. Another just-like-yesterday day in paradise. Come to Orange County. It's no place like home."
Last week, most Americans were probably thanking their lucky stars that they did not live in Orange County. The well-heeled, conservative Southern California region -- with an average household income of $57,000 and an airport named after John Wayne -- was the unlikely epicenter of a major financial earthquake whose aftershocks were felt across the country. Faced with at least $1.5 billion in losses on its super-high-risk $7.5 billion investment fund, Orange County became the largest municipality ever to file for protection under Chapter 9 of the Federal Bankruptcy Code.
Debacle. The beleaguered county's problems can be traced to the aggressive financial strategy of former Treasurer Robert Citron. To turbocharge his fund's returns, Citron borrowed $12.5 billion and poured the money into a portfolio that held interest- sensitive derivatives, financial agreements whose values are based on an underlying asset such as a bond. But as the Federal Reserve Board steadily boosted interest rates this year, Orange County got caught in a bind: It had to pay more on its borrowings than it was earning on its investments. This spread, coupled with the declining value of his bond portfolio, led to the Orange County debacle.
The financial reverberations were powerful. Dozens of municipal projects, from a new stadium for the Los Angeles Rams to a $1.5 million elementary school expansion in La Habra City, were put on hold. The city of Anaheim, which plopped a hefty $170 million into the county's investment pool, has imposed a hiring freeze and halted capital improvement projects -- moves that could hamper the Walt Disney Co.'s $3 billion development plans. The county also missed payment on a $110 million debt, which prompted Moody's Investors Service to downgrade the affected bond. Earlier, Standard & Poor's downgraded Orange County's long- term credit rating from a blue chip AA minus to a lowly CCC.
The tremors also raised the anxiety level on Wall Street. Merrill Lynch & Co., the nation's largest brokerage, played the biggest role in the ill-fated investment pool. The firm now faces a possible barrage of lawsuits from the 180 California cities and agencies that have their money tied up in the troubled fund. Predicts a former managing director of a major Wall Street investment bank: "It will be very, very expensive [for Merrill]." The relationship between Merrill and Citron also has come under scrutiny. Last week, it was revealed that Merrill Lynch employees had contributed $3,000 to Citron's political campaign. The firm denies wrongdoing. In a memo to his staff, Merrill Chairman Daniel Tully said, "At no time did Merrill Lynch act as Orange County's investment adviser."
The bankruptcy sent prices plunging in the $1.2 trillion municipal-bond market as investors fretted that other cities and counties might be holding equally risky investment funds. In fact, Orange County may not be alone. At least 25 states forbid local governments from investing in certain arcane financial instruments, but many others are free to do so. Recently, Ohio's Cuyahoga County lost a reported $114 million when forced to sell off bonds to cover a bad bet on falling interest rates. Some finance experts fear that Texas's huge $3.7 billion TexPool fund, which manages short-term investments for 1,300 municipalities, faces the same risks Citron did. TexPool has borrowed $1.3 billion to boost its total holdings to $5 billion. If, like many outstanding bond issues in 1994, those securities drop in value as interest rates rise, that will reduce the value of the collateral that TexPool has pledged against its loans. And San Diego County Treasurer Paul Boland says his county has $357 million in unrealized losses because its bonds fell in value while the Fed raised short-term interest rates this year.
Pressure. Bond investors are also worried that many municipalities have financial problems apart from their investment portfolios. While tax receipts have rebounded with the economic recovery, two thirds of large counties surveyed last year said revenues fell short of estimates. As a result, more than 60 percent said they had to raise user fees, fines or other sources of revenue. In addition, more than one third postponed capital-improvement projects, and more than 70 percent cut jobs. Tight budgets often increase the pressure on city and county treasurers. Next week, a fiscally battered District of Columbia government will plead its case on Wall Street, where it must convince lenders to keep the credit spigot open. The temptation to invest aggressively can be hard to resist. For a city such as Philadelphia, which has roughly $600 million of invested funds at any time, a 1-percentage-point improvement in portfolio performance means an extra $6 million in city coffers. Says Robert Inman, a professor at the University of Pennsylvania's Wharton School: "A small swing in investment results is the difference between a tax hike and a tax cut, or whether the swimming pools stay open all summer."
There's no shortage of swimming pools in Orange County, but the financial chaos could slow the county's economic recovery. Racked by recession, the region has shed almost 41,000 jobs in four years. Before the bankruptcy, analysts were predicting the creation of 21,000 jobs and 6.2 percent growth in personal income for the area's 2.6 million residents. But now forecasters expect 4,000 fewer new jobs in 1995.
At some point, everyone in Orange County will pay the price for the financial disaster. The most likely scenario: higher taxes in one of the nation's most famous antitax bastions. In addition, Orange County's cost of borrowing will jump -- and that will hit taxpayers, too.
In the days and months ahead, the fiasco in Orange County is sure to increase the pressure on local officials across the country. They will be asked to more closely monitor the billions of tax dollars that are invested by states and municipalities. Declares a senior Bank of America executive: "You can bet the ranch that every public agency is talking to their treasurer as we speak."
Orange County is too affluent not to recover from the Citron affair. But the conservative coastal enclave's trust in government is now at an all-time low. In a U.S. News forum on CompuServe last week, one angry Orange County resident proposed a new bumper sticker: "It's 10 p.m. Do you know where your tax dollars are?"
