O.C. IN BANKRUPTCY : Protection Filing May Spark Panic Selling : Bonds: Big investors may face heavy losses on current issues, and county could be shut out of market for new offerings.

Orange County’s dramatic decision to seek bankruptcy protection Tuesday is likely to touch off some panic selling of existing bonds today and kill the county’s ability to return to the bond market in the immediate future.

While the bankruptcy freezes the county’s repayment obligations and gives it time to assess its finances, it will force many large investors to sell at steep discounts, because there are legal restrictions on the amount of troubled debt they can hold in their portfolios, said John Schotz, president of Saybrook Capital, a Los Angeles investment banking firm.

And less sophisticated individual investors are likely to follow suit, said Lewis G. Feldman, head of the capital markets group of Cox, Castle & Nicholson, a Los Angeles public finance law firm.

Further curtailing the county’s ability to raise future bond money were decisions Tuesday evening by Moody’s Investors Service to suspend the county’s bond ratings and by Standard & Poor’s Corp. to slash its rating on all Orange County debt. Officials at both rating agencies said they could cut the county’s ranking to Triple-C as early as this morning, which would rank them as “poor quality� junk bond investments.

In announcing its suspension, Moody’s said: “There is little precedent to draw upon to predict the degree to which the federal bankruptcy court will protect debt holders.�

The anticipated downgradings are one of the factors likely to force institutional investors to start dumping Orange County bonds this morning, said Schotz.

Panicky investors already tried to unload Orange County bonds Tuesday, only to find that no one wanted them. And if it was difficult to sell the county’s paper without drastic discounts before the Chapter 9 municipal bankruptcy filing, it will only become more difficult.

That, however, could create an opportunity for speculative investors who have faith that the county is a safe long-term bet and who would offer to buy bonds at much-reduced prices. “People used the same approach to pick up junk bonds and real estate when those markets hit the skids,� Feldman said.

“The long-term prospects for Orange County are excellent,� agreed Jeremy Ragus, California Tax Free Fund portfolio manager at Scudder, Stevens & Clark in Boston. “There is no real general obligation debt� that encumbers the county’s tax revenue “and it is a fast-growing, high-energy, wealthy community that is going to survive this.�

The Orange County Sanitation Districts found out Tuesday how scant the market was for Orange County debt. The agency could not find a buyer for $4 million worth of its notes--basically interest-bearing IOUs--as it tried to complete a scheduled refinancing of the paper, said Steve Kozak, the districts’ financial manager.

Richard G. Paget, managing director and head of the municipal bond department at Baltimore-based Alex. Brown & Sons, said the situation “reminded me of the run on banks in the 1930s,� when everyone tried to get their money out at the same time. “The situation was simple,� Paget said. “People wanted their money out and couldn’t get it.�

After offering prices of Orange County bonds continued to plunge Tuesday, they were generally 15% less than those of similar bonds from other municipalities. Prices are likely to fall much further today.

While uncertainty about Orange County’s situation kept its bondholders and bankers on edge Tuesday, the overall bond market had a strong day as traders grew optimistic that the Federal Reserve has raised interest rates enough to flatten inflation.

Bond yields fell, continuing a weeklong rally in market prices. As yields fall, bond prices rise. The market’s benchmark, the 30-year Treasury bond, was up 52.5 cents as its yield fell to 7.87% from 7.92%.

“Everyone is scrambling, we’re under pressure to find (Treasury) bonds� because of high demand, said Rissy Mell, a trader at Josephthal, Lyon & Ross in New York.

Even foreign trading was affected as news about Orange County’s problems spurred heavy bond sales on the Tokyo Exchange, traders there reported.

On Wall Street, however, conflicting rumors and reports about the Orange County situation “continue to foster a misinformed market� for those bonds, one trader said.

A senior executive at one of the four biggest Wall Street firms, who declined to be identified, said Orange County’s bankruptcy was made inevitable after it hired a private firm that began approaching leading brokerages Monday to try to liquidate the county’s huge holdings of derivatives--a type of security whose value is linked to the market value of an underlying stock, bond, index or commodity.

The executive said all of the firms approached turned the county down. They rejected taking on such a monumental task partly because they found that the funds’ losses on the derivatives were much larger than the $1.5 billion that has been publicly reported. He declined to give a specific figure but said his firm concluded that it’s “hundreds of millions� more than that, although not double the amount.

It isn’t only large institutional bondholders who are asking questions that so far have no answers.

“What does it mean?� bemoaned retiree Jack Brownstone, a Rancho Mirage resident who owns about $15,000 worth of Orange County bonds. “What happens to the value of my bond? Is it like when New York went bankrupt and the state guaranteed the funds?�

Diamond Bar resident John Anderson, who says he owns a number of Orange County bonds through a municipal bond mutual fund, said Tuesday that he’s afraid he could lose much-needed retirement income and is outraged that “somebody was allowed to mismanage funds to this degree.�

Former county treasurer Robert L. Citron resigned Sunday amid increasing criticism of his high-risk investing style, but Anderson wonders if the blame should be placed on Citron alone.

“I don’t know how a person could be given that much authority without anyone else knowing about it,� Anderson said, suggesting that county supervisors and financial officials of other agencies that collectively invested more than $7.5 billion through Citron should have exercised more oversight.

Given that government bankruptcies are rare, with the laws governing them somewhat different than for other bankruptcies, even some sophisticated money managers were clueless Tuesday about the impact.

“Threatening to file bankruptcy is hysterical behavior unless there is something there that we don’t know, (perhaps) that liabilities outweigh assets� in the county pool, said Fred Prager, a partner with the San Francisco bond trading firm of Prager, McCarthy & Lewis.

“This is groundbreaking material here,� said W. Peck Ferrin, head municipal trader for Bank of America in San Francisco. “None of us has a handle on exactly what a Chapter 9 does� or how it affects bondholders. Bank of America is a leading underwriter of county bond issues.

Another major underwriter may have felt a sting from the bankruptcy rumors that circulated all day Tuesday. Merrill Lynch & Co., which has loaned the county $2.5 billion to purchase securities, saw its common stock drop $1 to $36.25 in heavy New York Stock Exchange trading.

Bond Ratings: What They Mean

Municipal bonds are rated according to their likelihood of going into default--the inability to pay interest to bondholders. Those rated AAA are considered least likely to default. Tuesday one of the nation’s two major rating services, Standard & Poor’s, indicated it is likely to drop Orange County’s rating from AA to CCC. What the ratings signify:

Moody’s Investors Standard Rating explanation Service & Poor’s Highest quality Aaa AAA High quality Aa AA Upper medium grade A A Medium grade Baa BBB Predominantly speculative Ba BB Speculative, low grade B B Poor quality Caa CCC Highest speculation Ca CC Lowest quality, no interest paid C C In default DDD In arrears DD Questionable value D

Source: Barron’s Dictionary of Banking Terms