MESS A L'ORANGE

By DAVID VAN BIEMA

What could be more benign than that boy scout of financial instruments, the municipal bond? What town has not floated an issue to build a road? What little old lady (or big mutual fund) has not heard an accountant extol "munis" as the most foolproof of investments? Lending to companies is risky: they fold overnight, leaving squabbling creditors. But municipalities don't disappear from the map; and knowing they will borrow more tomorrow, they will do anything -- even raise taxes-to avoid defaulting today.

Or so it seemed until an extraordinary vote last Tuesday in Southern California's Orange County. Since its former treasurer bankrupted the county last year by gambling on high-risk investments, Orange has searched for ways to back up its $2 billion debt. The traditional method for large municipalities in trouble has been a sales-tax increase. But last week, by a 3-to-2 ratio, Orange County's voters spurned tradition and rejected an increase. Their decision plunged the county's future -- and perhaps that of municipal bonds -- into uncertainty. Says county chief executive William Popejoy: "We have shot ourselves, not necessarily in the foot but maybe in a more painful part of the anatomy." Some would suggest the head.

The trouble began with former treasurer Robert Citron, who has since pleaded guilty to misappropriation of funds. Yet the bankruptcy need not have been ruinous. Orange County is vastly rich: its gross economic output of $77 billion is about the same as Greece's. According to a study, the proposed sales-tax increase of a half-cent per dollar would have cost the average resident only $50 a year while reaping $140 million in tax revenue, enough to procure a new loan to cover the county's maturing obligations.

But Orange County has a tradition of hostility to taxes. Many residents have yet to feel acute pain from the 41% cut in the county budget imposed since the bankruptcy: teachers stayed in the classrooms, and fire stations remained open. Above all, voters saw a yes ballot as an inappropriate affirmation of the county's supervisors, most of whom presided over the Citron debacle. Says Wayne Barber, a communications consultant in Irvine: "If even one of the bastards had resigned, I would have voted yes."

Now the county, which has a discretionary-spending budget of $275 million, must find another way to make up the $140 million a year that the tax increase would have raised. The prospect horrifies county sheriff Brad Gates, who predicts he will have to close the county's crime lab and bomb squad and release prisoners early, and that the D.A. will prosecute only the most serious crimes. Others claim he is an alarmist and that by selling assets like the John Wayne Airport the county can meet its obligations. Claims Supervisor William Steiner: "There is no interest by this board in stiffing the bondholders."

But Wall Street was not convinced. In addition to downgrading Orange County bonds to junk status last week, Moody's Investors Service called the county's behavior "outrageous and unprecedented." Says Zane Mann, publisher of the California Municipal Bond Advisor: "People are saying, 'Screw them. I'll never buy another Orange County bond as long as I live.'" This anger has larger financial implications. An Orange County default could push up the interest rate on all munis, so that taxpayers everywhere would be forced to pay more to build a school or a road.

The county may be able to wriggle out. Popejoy hints that it still has a chance of recouping millions through a legal settlement with Merrill Lynch, the brokerage the county claims misled Citron. In the meantime, a bankruptcy judge has given Orange County permission to ask creditors for a year's grace on $800 million due this summer. They may go along, hoping that the county will get lucky. Or they may simply decide to get what they can from a $452 million county fund being held in reserve, and write off the rest.

Another, increasingly likely scenario is that the state will take over. This would not mean a bailout: California itself is strapped, and many state politicians are less than sympathetic to what Democratic state assemblyman Wally Knox describes as Orange County's "trying to extricate itself by banging on a tin cup with a silver spoon." Instead, the state treasurer has suggested appointing a trustee to manage Orange's money. If that happens, the county's fierce opposition to Big Government will have brought California's biggest government right into town.

---Reported by Dan Cray/ Los Angeles and Sribala Subramanian/New York

With reporting by DAN CRAY/LOS ANGLES AND SRIBALA SUBRAMANIAN/NEW YORK