The sudden plunge of Orange County, Calif., into bankruptcy shook the market for public borrowing across the country yesterday, threatening to make it more expensive for many local governments to borrow. It also left some Wall Street firms facing the potential of big losses.
And it served as a warning of how rapidly new and popular financial strategies can sour, leaving an apparently prosperous county unable to pay its bills.
Orange County, a suburban area south of Los Angeles, filed for bankruptcy late Tuesday after heavy borrowing and risky investments in its investment pool turned into big losers as market interest rates rose.
The investments had been made by a county desperate to get additional profits on its investments for itself and other localities to pay for government services. But the fund, with about $8 billion invested in it -- and with borrowings of about $12 billion -- now faces a loss of at least $1.5 billion.
The county was able to meet its daily expenses yesterday because Chapter 9, the bankruptcy provision under which it filed, allowed that even without judicial approval.
"The county has use of all its finances," said Bruce Bennett, the bankruptcy lawyer at Stutman, Treister & Glatt who is handling the case. "We are clearing all checks. Welfare checks went out today."
But the municipal bond market -- one of the largest in the country, with more than $1 trillion in outstanding issues -- was shaken by the bankruptcy of a borrower that had been viewed by rating agencies as one of the safest.
Traders said the bonds from most California issuers were quoted at sharp drops in prices -- with yields about 40-one-hundredths of a percentage point higher than Tuesday's level -- but there was no activity in them.
"There is no market in California issues," said Austin Tobin, president of Delphis Hanover Corp., which prices municipal bonds for professional investors. "There probably won't be one for a couple of days."
Standard & Poor's Corp. downgraded Orange County's debt to the status of junk bonds.
The impact of the bankruptcy filing was felt in municipal bonds across the country, with the yield on the Bond Buyer municipal bond index leaping to 7.06 percent yesterday, from 6.92 percent Tuesday, while the rates on taxable Treasury bonds rose much less.
Much of the decline represented buyers pulling back in fear that there were other Orange Counties still awaiting disclosure. It seems unlikely that any other county official invested quite as recklessly as did Robert L. Citron, who was forced to resign as the Orange County treasurer Monday, but other governments took risks that may subject local taxpayers to losses.
"More losses will come out," said Joe Mysak, editor of Grant's Municipal Bond Observer, a New York publication that follows the municipal market. "The municipalities will blame Wall Street and the tight financial situation they are in."
The Wall Street exposure stems from billions of dollars in loans that firms made to Orange County's investment fund and to the possibility of lawsuits from the county stemming from the risky investments.
The largest investment bank to deal with Orange County was Merrill Lynch, whose shares fell $1.25, to $35, on the New York Stock Exchange yesterday. Merrill Lynch said its $2 billion in loans to the county were fully collateralized, but there were worries that it would be sued.
The Orange County fund had borrowed heavily to speculate on interest rates staying low or declining. As the rates have risen this year, the county's losses mounted, but until last week, the county maintained that there was no problem.