The culprits of Orange County

FORTUNE — As was inevitable given the temper of the times, the December revelations about investment disasters in Orange County, California, were immediately converted into headlines with “derivatives” writ large. But in actuality, these newfangled concoctions were only a part of the problem that did the county in. The true roots of this fiasco were those ageless rascals, stubbornness and borrowed money.

The locus of all this trouble was the Orange County Investment Pool, into which the county and its cities, school districts, and special districts deposited their tax receipts. This fund owned almost no derivative contracts but had buckets of derivative securities. Most of these were “structured notes,” a name arising from the fact that the issuers of these notes, among them such parties as the Federal Home Loan Banks (FHLB), structure their terms to fit the investment wishes and opinions of particular institutional buyers. If he chooses, a buyer with strong convictions about the market may sign up for a package that combines the lure of above-market returns with extra risk. In other words, he rakes in money if he’s right about the market but loses his shirt if he’s wrong.

For example, the Orange County pool held large quantities of “inverse floaters,” a kind of structured note whose value is often linked — this is where derivatives come in — to the level of the London Interbank Offered Rate, familiarly known as Libor. If Libor goes down, the rates on the floaters do the inverse, going up. That means the noteholders earn handsome, above-market rates. But if Libor goes up, rates on the notes head for the cellar. Simultaneously, the market value of the notes declines, since they are carrying rates below those generally available in the market.

Throughout the early 1990s, the manager of the Orange County pool, county treasurer Robert L. Citron, had a view — totally accurate — that interest rates were going down and that bonds were therefore going up. Taking this conviction to the structured-note market, where he often enlisted the help of Merrill Lynch, Citron performed like an Olympian. The yields earned by the Orange County pool from 1991 to 1993 were a marvel, running above 8.5% during a period when bond mutual funds were averaging about 7%. Mightily impressed, Orange County’s municipalities shoved money into the fund, raising the size of their deposits from around $3 billion in 1991 to $7.6 billion in 1994.

Alongside, all the way, stood Merrill Lynch, represented in most cases by a San Francisco municipal specialist, Michael Stamenson, who recognized Citron as a very valuable asset. Merrill Lynch helped educate Citron about the derivatives market and sold him derivatives securities. It lent his fund money. And it made itself a leader in underwriting and distributing the securities offerings of various Orange County municipalities. Altogether, Merrill and Stamenson got a lot of juice out of Citron and friends.

But as early as October 1992, Merrill began talking to Citron about the “volatility” that he had built into his portfolio and suggesting he reduce it. Citron would have none of that plan, nor did he listen to other Merrill cautionary statements that came along later.

Instead, wanting to back his continuing and now wrongheaded conviction that interest rates were still heading down, he piled on borrowings — “up to his chin,” says Federal Reserve Chairman Alan Greenspan. In 1994 his core stake was the $7.6 billion that investors had deposited in the Orange County pool. To that he had added about $12.5 billion in debt, collateralized by securities held in the fund’s portfolio. Roughly $8 billion of the $20 billion total was in structured notes. So there was a derivatives problem here, yes. But leverage is what really did in Citron and his county.

The danger gathered force on February 4, 1994, when the Fed first tightened interest rates and sent fixed-income securities, including all those that Citron owned, into a grizzly bear market. By early December, the Fed had turned the screws five more times, and six-month Libor had gone from 3.6% to 6.8%. Wall Street’s brokers, who had provided Citron with most of his loans, were demanding additional collateral that he couldn’t supply. So some brokers sold their collateral, others mobilized to do so, and Citron’s whole jerrybuilt contraption tumbled.

Weeks later, after a team of financial medics had overseen the liquidation of the fund’s portfolio, the toll could be calculated: Of the $7.6 billion that Orange County’s municipalities had put up, a stunning $1.7 billion had been lost. The ramifications for these investors are large: They are now struggling with their budgets, cutting back services, and fighting among themselves as to how the losses should be divided. And Orange County, of course, has filed for bankruptcy.

Meanwhile, Orange County and Merrill Lynch are no longer friends. The county has sued Merrill, charging that it “encouraged” Citron to invest in securities that, by the laws of California, were beyond the bounds of permissible risk. Merrill says it did nothing improper and denies being able to tell Citron anything.

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