SANTA ANA, Calif. - The $2.5 billion Orange County Employees' Retirement System is the biggest pension fund loser in what might come to be called the Orange County derivatives disaster.
The retirement system held an emergency meeting last week to deal with massive custody, liquidity, benefit payment and potential litigation issues following the county's filing for Chapter 9 bankruptcy protection. The county's pooled fund - the investment vehicle that suffered $1.5 billion in losses - also filed Chapter 9 protection.
Part of the trustees' action was aimed at making sure beneficiaries are paid as usual in early January and to avoid putting more money into the county treasurer's account.
Fund trustees granted authority to the staff to:
Switch several payment and receivable accounts from Orange County offices to its custodian, Boatmen's Trust, St. Louis, and establish appropriate accounts.
Change Boatmen's Trust's status to master trustee from master custodian, if needed.
Begin a search for a law firm for the fund for potential litigation.
Demand Orange County turn over to the retirement system about $128 million in assets in the pooled fund, now frozen.
Temporarily stop plans to reduce the county's contribution to the fund in connection with proceeds of pension obligation bonds paid to the retirement fund.
Another pension fund victim is the city of Irvine, which had most of its pension fund assets invested in the treasurer's pool. Irvine had $15 million of its $20 million defined benefit fund and $12 million of its $24 million defined contribution fund with the treasurer. Other details were unavailable.
Other victims - besides California municipalities that had money invested by the Orange County treasurer's office - were buyers of municipal bonds, especially pension obligation bonds, which dropped in value when the disaster unfolded.
One fixed-income manager warned the disaster could cause a "crisis of confidence" in the financial system.
But the $320 million St. Louis Employees' Retirement System avoided the disaster. Its $500,000 in Orange County bonds matured July 1. The bonds were part of a portfolio managed by 1838 Investment Advisors, Radnor, Pa.
According to John H. Donaldson, 1838 principal and portfolio manager, all principal and interest on the bonds were paid in full on time when they matured.
Wall Street precipitated crisis
The bankruptcy filings came when Wall Street investors demanded the county repay $1.2 billion in loans to its investment pool.
The Orange County retirement system was the fifth largest investor and largest pension fund investor in accounts managed by Treasurer Robert L. Citron. The pension fund had almost $125 million invested with Mr. Citron as of Nov. 30, according to Terry Slattery, investment analyst for the fund.
But an inventory of investors released by the treasurer's office as of the same date showed the pension fund had about $133 million.
Mr. Slattery said $59 million was in the pooled fund. Another $65 million was in a separate account also managed by Mr. Citron. That account sustained no losses or liquidity problems, Mr. Slattery said. The separate account assets came from the September sale of $320 million in pension obligation bonds.
He and Mary-Jean Hackwood, fund executive director, said the $65 million is allocated to real estate but hasn't been drawn down by money managers yet. Ms. Hackwood said, however, the $65 million was invested in the pooled fund.
"Our understanding is that all the money, all proceeds (of the treasurer's investments) are frozen under the bankruptcy provision. .*.*. We have not had communication back from the (county) treasurer's office," she said.
'The market went against them'
Speaking of the Orange County treasurer's investments, Mr. Slattery said: "We'd had great returns. The market went against them.
"The treasurer was to outperform the return of short-term cash funds at a very high level of liquidity and principal safety," he added.
Said the pension fund's consultant, Michael J. O'Leary Jr. of Callan Associates Inc., Denver: "In 1994, he began to use derivatives and extend maturities. Prior to that it was a repo strategy (with matched maturities).
"The treasurer came in the spring of 1994 (to the pension fund) for due diligence to describe what he was doing. (That was the last such meeting they had.) My sense is he, subsequent to his meeting, increased his use of leverage, started to use inverse floaters and extended the maturities of the underlying securities."
He added, "The treasurer's office had described to the retirement system his liquidity and said he had $2 billion of liquidity and was cognizant of mismatches of collateral (in terms of maturity)."
Both Mr. Slattery and Ms. Hackwood said the Orange County fund's short-term assets are divided between the Orange County pooled fund and a short-term fund at Boatmen's.
The retirement system also has a $7 million operational fund in the county pooled fund, Ms. Hackwood said. The operational fund pays system bills and monthly benefits.
Contribution payments in doubt
The county bankruptcy filings have raised questions about the county's ability to make timely pension contributions. "We hope they will," said Ms. Hackwood, but "no calls are being returned (to us) from the county."
Orange County pension fund trustees were forced to open new accounts at Boatmen's because the fund has been using county offices to issue and approve payment checks. It also used the county treasurer's office for check clearing.
By tradition and statute, the county has been the pension fund's custodian, but Mr. Citron had agreed to give Boatmen's custodial power for all but part of the plan's short-term investment fund.
Ms. Hackwood said Boatmen's will assume master trustee status if the bank assumes responsibility for making retirement benefit payments. Boatmen's will be responsible for petty cash, open accounts, retiree payments, refunds, contributions and adjustments.
When asked if the system has enough liquid assets to meet benefit obligations, Ms. Hackwood said, "I am not stating that there is or is not. I am stating that we want to take appropriate action so that there is no problem."
Looking at legal issues
At the pension fund's special meeting Dec. 7, Lawrence Behrendt, an attorney with Fatica, Boutwell & Behrendt, Los Angeles, warned trustees about possible legal issues they face.
He said if the county establishes that the retirement system isn't a creditor, the chances of the fund getting its money back might be lessened. He said a brokerage could sell collateral used by the county for investments in repurchase partnerships, if bankruptcy protections are removed.
He said if the county had pledged assets in making investments, it probably had the authority to do so.
A crisis of confidence
Philip Barach, managing director at TCW Asset Management, Los Angeles, said the Orange County debacle could be the biggest contributor to a brewing "confidence crisis" in the financial system.
Although he has no direct knowledge of other instances, Mr. Barach said "there's a high probability" other public pools copied Mr. Citron's investment strategy.
Mr. Barach said while the public generally doesn't understand what happened in Orange County, cracks are appearing in the financial system that could erode confidence. The public knows money has been lost by municipalities and that interest rates are rising, he said.
Sonoma County, Santa Rosa, Calif., plans to unwind its $138 million in leveraged reverse repurchase agreements as they mature because of the perceptions about the investments caused by the Orange County crisis and because brokers may be unwilling to do deals at reasonable prices for a while, said Donald W. Merz, treasurer and tax collector.
He said Sonoma's reverse repos use "a safe leverage," matching the maturity of the repo with the leveraged assets, unlike Orange County.
He said the pool has had no investment problems, nor does he expect any because of the maturity matching of the repos.
Sonoma County was the first in California to issue pension obligation bonds, selling $97 million in October 1993 to finance its unfunded pension liabilities. Mr. Merz said those bonds have had no problems.
County not alone in losses
Orange County was not the only public money pool to experience investment losses this year. TexPool, a $3.8 billion investment pool for local government entities in Texas, has $60 million in unrealized losses, said John Bell, Texas assistant deputy treasurer. None is pension money. He said the loss is not unusual given this year's downturn in bond prices.
He said the fund does reverse repurchase agreements, but only on a matched book basis - the maturity of the reverse repurchase agreement (basically a loan) matches that of the investment of the proceeds from the reverse repo. "It isn't risky," he said.
He said the TexPool's use of reverse repos is different from what Orange County reportedly did. "They borrowed short and went (invested) long," he said.
Some funds saw it coming
Some public pension funds had taken steps earlier to avoid problems with leverage or derivatives. The Louisiana School Employees' Retirement System, Baton Rouge, with nearly $1 billion in assets, last year added a section in its investment policy prohibiting its managers from investing in direct coupon collateralized mortgage obligations without prior approval of the board of trustees, said Julia LeBlanc, chief investment officer.
Since then, no manager has requested approval, she said. She said the fund does not hold any reverse mortgage repurchase agreements. Last week, the board asked each of its managers to report on derivatives holdings. Trustees are awaiting the reports.
In Orange County, meanwhile, some $65 million, or about half of what the Orange County Employees' Retirement System invested with the treasurer's pool, was part of the proceeds the pension fund received from the county's issuance of $320 million pension obligation bonds in September. Those pension bonds have plummeted in value because of the financial crisis created by the treasurer.
Standard & Poor's Corp., New York, downgraded all of Orange County's debt, including its pension obligation bonds, to CCC, its lowest rating, because of the bankruptcy filing. Moody's Investors Service Inc., New York, "suspended" its ratings of Orange County.
The market turmoil caused by Orange County affected pension obligation bonds issued by Los Angeles County, Chula Vista, Fresno, Contra Costa County, San Diego County and Sonoma.
Said Robert J. Froehlich, head of research at Van Kampen Merritt Cos., Oakbrook Terrace, Ill.: "The ripple effect of Orange County has been dramatic in the market.
"The pension obligation bonds are a small part of the market. The overall California municipal market has really been penalized. It's down an additional 1 to 1.5 points from the rest of market. The whole muni market has received a penalty, and the California market more so. So anything with a California name is going to find its trading off in the market place; it will have a terrible liquidity squeeze and will have trouble finding buyers."
Ronald J. Surz, consultant, Pension Performance Consulting Alliance, Wheaton, Ill., called pension obligation bonds "an arbitrage."
The issuer (the county or city that sponsors the pension fund) issues the bonds to cover all the unfunded liability of the pension fund, hoping the pension fund can invest the proceeds at a higher rate than its actuarial rate, he said. Thus, the county hopes to reduce by a few hundred basis points the cost of contributing to the pension fund to make up for the unfunded liability.
"The only way the leverage will work is if you can earn more on the investment than you pay out in interest," Mr. Surz said.
Orange County issued $320 million in pension obligation bonds, but it already has jeopardized the $65 million of that, or 20%, invested with the Orange County treasurer. So the pension fund would have to earn more than 20% just to get back the $65 million, depending on how much of it is lost, Mr. Surz suggested.
In addition, the pension obligation bonds harm the debt capacity of the county.
But for beneficiaries, pension obligation bonds are "a great thing, because they have the money in the pension fund."
Christopher J. Ailman, CIO of the Sacramento County Employees' Retirement System, said the county had planned to issue $340 million in POBs in May but postponed the issue because of rising interest rates. He said the county still will issue them when rates are below 6.75%.
This story was written from reports by Barry B. Burr, Paul G. Barr, Steve Hemmerick, Christine Philip and Mercedes M. Cardona.
