(FORTUNE Magazine) – The typically lackluster world of municipal finance was thrown into the spotlight when Orange County, California, filed for bankruptcy last December 6. Former county treasurer Robert Citron leveraged a $7.4 billion portfolio to about $20 billion by putting the original securities up for collateral in order to purchase new bonds, including ones with embedded derivatives called inverse floaters, whose value declined as interest rates rose. By December 12 the fund faced losses of over $2 billion. Casualties: schools, cities, and the few fans of Anaheim's hapless Los Angeles Rams, whose team may move to St. Louis owing to insufficient funds to rebuild their stadium.

Essentially, the treasurer bet that interest payments he earned on long-term bond investments would exceed the interest the county owed on short-term obligations. But Citron's strategy soured when the gap between long and short rates began to dwindle and he could not meet the margin calls demanded by the Wall Street firms holding his collateral (which they then proceeded to sell en masse).

The debacle brought a chorus of I-told-you-so's. When John Moorlach ran against Citron in the race for county treasurer last summer, he did in fact warn the chairman of the board of supervisors that the investment pool might "implode" if interest rates continued to rise. Laments Moorlach, now plying his trade as a CPA: "Everyone looked at me like I was Chicken Little."

No more. After Citron resigned, the former treasurer of California, Thomas Hayes, took over the mess at the request of Governor Pete Wilson. Hayes's primary goal is to restructure the risky portfolio. Working with Salomon Brothers, he initially sold about $1.5 billion of the fund's securities, but most of the proceeds went to pay collateral claims. Hayes also started negotiating with agencies like Fannie Mae and Sallie Mae that issued some of the securities, trying to strip them of their derivative components in order to sell them more easily.

Proper oversight from the county supervisors was lacking. Disclosure about the pool's leverage and collateral arrangements from investment houses that underwrote the county's bonds also appears underwhelming. But Merrill Lynch, which underwrote a $600 million July offering, insists in a statement: "Any suggestion that Merrill Lynch failed to disclose the risks associated with investments purchased from us is utterly preposterous." Nonetheless, both the SEC and the Commodity Futures Trading Commission are looking into Merrill's involvement with the county.

- Erick Schonfeld