California's Orange County filed for bankruptcy protection last Tuesday and defaulted on a $110 million issue of taxable pension obligation bonds on Thursday. The municipal bond market's recent rally aborted, and Securities and Exchange Commission chairman Arthur Levitt said the events were "significant" and "may cause grief and loss to many people." The municipal bond market faces its gravest test in more than a decade.
When Orange County's problems are finally settled - and like New York City in 1975 or the Washington Public Power Supply System in 1983, they will take years to unfold and solve - governmental money funds will be controlled more tightly and more rationally. They will be marked to market, and leverage will be firmly restricted.
The most unsettling news to emerge last week was that local governments in Orange County had borrowed in the taxable fixed-income market to speculate in the county's highly leveraged pool. The Newport-Mesa Unified School District, for example, issued $47 million of taxable notes last June to earn arbitrage income, which is an unwise practice for a school district, in our judgment. Other taxable borrowing last June brought the total for such bets to about $200 million.
The official statements for these note sales said the money would be held by the Orange County treasurer-tax collector on behalf of the note issuers, a description that is hardly candid.
Matthew Raabe, Orange County's acting treasurer, wrote a letter to the Newport-Mesa school district to explain how the proceeds from the note sale would be invested, a transaction he described as "complicated" because it involved reverse repurchase agreements. "Only after relating the positives and negatives to you, and that the negatives or risks were very minimal, did we agree to this financial transaction," Raabe wrote. The letter also stated, "There is no risk related to the $46.96 million principal amount."
The district had earned $1.1 million the first year it sold such notes, and this year it expected to earn $700,000, a figure revised downward following the disclosure of the $1.5 billion paper loss of the county's intergovernmental investment pool. That's one way for a school district to help pay its expenses, but it's not advisable, we assert.
Last week amid the Orange County turmoil, Michael Fine, fiscal director of Newport Mesa; Leslie Lynch of Rauscher Pierce Refsnes Inc., underwriter of the notes; and Lawrence Rolapp of Fieldman, Rolapp & Associates, financial adviser, all dodged the most important question: Is borrowing to earn arbitrage income good public policy? The answer is no.
